Can we blame the yen for the recent market decline and severe rotation from large to small caps? Before discussing the yen and its potential role, it’s important to disclaim that this is just one possible theory to explain the recent violent market decline and rotation.

The yen carry trade occurs when hedge funds and other institutional investors borrow in yen at near-zero interest rates. They convert the yen to dollars and buy stocks and bonds. This leveraged trade depends on Japan’s low borrowing rates and a weak yen as the funds are essentially short yen. A sharp yen appreciation versus the dollar could generate a margin call from the lending bank, forcing the firm(s) to liquidate the trade quickly.

On July 11, CPI was weaker than expected. As the data was released, the yen shot higher versus the dollar as the BOJ intervened in the currency markets. Despite the good CPI data, the Nasdaq got hammered, and the small-cap Russell 2000 surged. From then on, the markets began experiencing a downward trend, and yen appreciation continued. Might some yen carry trades have been buying large caps while short small caps? If so, they may have been forced to reverse out of the trade in a hurry when the yen appreciated. While it’s just a theory to help explain the recent market decline, the graphs below give it some credence.

What To Watch Today

Earnings

Economy

Market Trading Update

In yesterday’s commentary, we noted that the current corrective process was similar to that seen in April when the market broke the 20-DMA and eventually challenged the 100-DMA. Of course, whenever there is a market decline, we humans must try to rationalize the “chaos” by assigning a reason to it. The most recent rationalization is that the “AI trade” is dead. As noted by the better-than-expected revenue and earnings from Google (GOOG), most earnings growth comes from the largest companies. As such, we seriously doubt that managers will abandon these companies anytime soon. Furthermore, given that hedge funds need to move large amounts of capital at a time, these large-cap companies are the only companies that provide the needed liquidity.

However, every time these “Mega-Cap” companies pull back, the media assigns a new rationale for why it is happening. The reality is that these companies have posted stellar returns this year, and a bit of profit-taking is unsurprising, just as we have seen at each previous market peak over the last two years. The chart below compares the darlings of the “AI trade,” Apple (AAPL), Microsoft (MSFT), Google (GOOG), and Amazon (AMZN) to the S&P 500 index. (I would have included NVDA, but it has rallied so much that it skews the chart too much.)

When the S&P 500 index advances or declines, there is a high price correlation with the “Mega-Cap” stocks. That correlation should be unsurprising because they make up ~35% of the index. The crucial point is that the current correction is likely just like every other correction we have seen over the last few years. It is highly likely that when this current corrective process concludes, large-cap stocks will once again resume their leadership.

Airline Sale

The large U.S. airlines are having a sale. Unfortunately, it’s not on ticket prices but their share prices. Despite booming air travel, as shown below courtesy of Statista, U.S. airline stocks are trading near their pandemic lows. To stress that point, airline share prices are at similar levels as when air travel was all but shut down, and there was no clear timetable for when it would resume. The second graph shows American, United, and Southwest Airlines.

Focusing on American Airlines (AAL) as an example, its revenues are at record highs commensurate with the TSA data. Furthermore, its EBITDA is back to pre-COVID levels, albeit showing little signs of growth despite higher revenues. Operating margins have been declining, eroding their profits. While little earnings growth weighs on investor sentiment, its valuations have become dirt cheap. AAL has a P/E ratio of 4.5 and a P/S of 0.13. There is value, but as we have been well aware for quite a few years, value is not in vogue.

Hedge Funds Arent Hedged

We opened by discussing the yen carry trade and how it could be behind the recent stock market decline, rotation, and volatility. However, we would be remiss if we didn’t consider the graph below. Hedge funds were not hedging their stock bets with S&P futures or options. They may have been hedged via shorts on the Russell 2000 small-cap index. Given the recent decline, they may now be rushing to hedge their stock position or cover their Russell short hedges.

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Overly optimistic investor expectations of market returns may be a problem. To wit:

“While consumers are not very confident about the economy, they are highly optimistic about the stock market. In that same consumer confidence report from the Conference Board, the expectations for rising stock prices over the next 12 months are near the highest on record.“

Of course, after a decade of 12% returns, why should they not be optimistic that the future will be much the same as the past? A good example came from a recent discussion with an individual wanting me to review the “financial plan” for their retirement goals. The plan was generated by one of the many “off the shelf” software packages that take all the inputs of income, assets, pensions, social security, etc., and then spits out assumptions of future asset values and drawdowns in retirement.

The problem is that the return assumptions were grossly flawed.

In the vast majority of these plans, the optimistic assumption is that individuals will have a rate of return of somewhere between 6-10% annually heading into retirement and 4-8% thereafter. The first major flaw in the plan is the “compounding” of annual returns over time, which does NOT happen.

“There is a massive difference between AVERAGE and ACTUAL returns on invested capital. Thus, in any given year, the impact of losses destroys the annualized “compounding” effect of money.

The chart below shows the difference between “actual” investment returns and “average” returns over time. See the problem? The purple-shaded area and the market price graph show “average” returns of 7% annually. However, the return gap in “actual returns,” due to periods of capital destruction, is quite significant.”

The second and most important is the future expectation of individual returns over the next 10-20 years.

This second point is what I want to address today.

There are two main reasons why returns over the next decade or two are currently overestimated. The first is a “you problem,” and the second is “math.”

It’s A You Problem

Back in 2016, I wrote an article discussing a Dalbar investor study explaining why investors consistently “suck” at investing. As I detailed in that article, one of the biggest impediments to achieving long-term investment returns is the impact of emotionally driven investment mistakes.

Investor psychology helps us to understand the thoughts and actions that lead to poor decision-making. That psychology drives the “buy high/sell low” syndrome and the traps, triggers, and misconceptions that lead to irrational mistakes that reduce returns over time.

As the Dalbar study showed, nine distinct behaviors impede optimistic investors based on their personal experiences and unique personalities.

The most significant problems for individuals are the “herding effect” and “loss aversion.”

These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are optimistic the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained that optimistic belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”

As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip”opportunity. As losses mount, the anxiety of loss begins to mount until individuals seek to “avert further loss” by selling.

As shown in the chart below, this behavioral trend runs counter-intuitive to the “buy low/sell high” investment rule.”

“In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision-making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

More importantly, despite studies that show that “buy and hold,” and “passive indexing” strategies, do indeed work over very long periods of time; the reality is that few will ever survive the downturns in order to see the benefits.”

The impact of these emotionally driven mistakes leads to long-term underperformance below those “goal-based” financial projections.

It’s Just Math 

“But Lance, the markets has returned 10% on average over the last century, so I will probably be okay.”

True. If you can contract “vampirism,” avoid sunlight, garlic, and crosses, you can live long enough to achieve the “average annual rate of return” over the last 124 years.

For the rest of us mere mortals, and why “duration matching” is crucial, we only have between today and retirement to reach our goals. For the majority of us – that is about 15 years.

And therein lies the problem.

Despite much of the commentary that continues to suggest we are in a long-term secular bull market, the math suggests something substantially different. However, it is essential to understand that when low future rates of return are discussed, it does not mean that each year will be low, but the return for the entire period will be low. 

The charts below show the 10- and 20-year rolling REAL, inflation-adjusted returns for the markets compared to trailing valuations.

(Important note: Many advisors/analysts often pen that the market has never had a 10 or 20-year negative return. That is only nominal and should be disregarded as inflation must be included in the debate.)

There are two crucial points to take away from the data. First, there are several periods throughout history where market returns were near zero and negative. Secondly, the periods of low returns follow periods of excessive market valuations. Such suggests that betting “This time is not different” may not work well.

As David Leonhardt noted previously:

“The classic 1934 textbook ‘Security Analysis’ – by Benjamin Graham, a mentor to Warren Buffett, and David Dodd – urged investors to compare stock prices to earnings over ‘not less than five years, preferably seven or ten years.’ Ten years is enough time for the economy to go in and out of recession. It’s enough time for faddish theories about new paradigms to come and go.”

History shows that valuations above 23x earnings have tended to denote secular bull market peaks. Conversely, valuations at 7x earnings or less have tended to denote secular bull market starting points.

This point is proven simply by looking at the distribution of returns as compared to valuations over time.

From current levels, history suggests that returns to investors over the next 10 and 20 years will likely be lower than higher. However, as I said, we can also prove this mathematically. As I discussed in “Rising Bullishness:”

“Capital gains from markets are primarily a function of market capitalization, nominal economic growth, plus dividend yield. Using John Hussman’s formula, we can mathematically calculate returns over the next 10-year period as follows:

(1+nominal GDP growth)*(normal market cap to GDP ratio / actual market cap to GDP ratio)^(1/10)-1

Therefore, IF we assume that GDP could maintain 2% annualized growth in the future, with no recessions ever, AND IF current market cap/GDP stays flat at 2.0, AND IF the dividend yield remains at roughly 2%, we get forward returns of:

(1.02)*(1.2/1.5)^(1/10)-1+.02 = -(1.08%)

But there are a “whole lotta ifs” in that assumption. Most importantly, we must also assume the Fed can get inflation to its 2% target, reduce current interest rates, and, as stated, avoid a recession over the next decade.”

In either case, these numbers are well below most financial plan projections, leaving retirees well short of their expected retirement goals. 

Conclusion

While most analysis assumes that individuals should “buy and hold” indexed-based portfolios, the reality is quite different.

Retirement plans have a finite period for asset accumulation and distribution. The time lost “getting back to even” following a significant market correction should be a primary consideration.

Unfortunately, most investors remain woefully behind their promised financial plans. Given current valuations and the ongoing impact of “emotional decision-making,” the outcome will not likely improve over the next decade or two.

Markets are not cheap by any measure. If earnings growth slows, interest rates remain elevated, and demographic trends impact the economy, the bull market thesis will disappoint as “expectations” collide with “reality.” 

Such is not a dire doom and gloom prediction or a “bearish” forecast. It is just a function of how the “math works over time.”

For optimistic investors, understanding potential returns from any given valuation point is crucial when considering putting their “savings” at risk. Risk is an important concept as it is a function of “Loss.“

The more risk taken within a portfolio, the greater the destruction of capital will be when reversions occur.

This time is “not different.” The only difference will be what triggers the next valuation reversion when it occurs. If the last two bear markets haven’t taught you this by now, I am unsure what will. 

Maybe the third time will be the “charm.”

In a stunning reversal of opinion, ex. New York Fed Governor Bill Dudley now calls on the Fed to immediately cut rates. In a Bloomberg article titled I Changed My Mind. The Fed Needs To Cut Rates Now, he states:

“I’ve long been in the ‘higher for longer’ camp…The facts have changed, so I’ve changed my mind. The Fed should cut, preferably at next week’s policy-making meeting.…Although it might already be too late to fend off a recession

Like ourselves, Bill Dudley is noticing a degradation of important but lesser-followed labor market data. He notes that the household employment survey from the BLS shows the economy only added 195k jobs in the last year. Conversely, the well-followed BLS establishment survey shows gains of over 2.6 million jobs. He also justifies his decision with the core PCE prices data showing that inflation is nearing the Fed’s 2% target. He concludes as follows:

Although it might already be too late to fend off a recession by cutting rates, dawdling now unnecessarily increases the risk.

The next FOMC meeting is next Wednesday. As we share below the market, pricing in a slim 6.7% chance of a rate cut, does not agree with the logic of Bill Dudley.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we discussed the average Presidential election year path for markets and the rules to follow to navigate this current corrective process. The correction that started last week continued yesterday despite good earnings and revenue numbers from Google (GOOG). Hence, with the market retesting and failing the 20-DMA, the 50-DMA becomes the next logical support.

So far, this correction is very close to what we saw in April. The market initially broke the 20-DMA, rallied above it, then failed and took out the 50-DMA, eventually finding support at the 100-DMA. If we replay that episode, the current correction will again encompass a roughly 5-7% decline from the previous peak. As of yesterday’s close, the market is testing the 50-DMA and is moving into more oversold conditions. The market needs to hold support here, or we will retest the 100-DMA once again, which we think is ultimately most likely.

That statement should be unsurprising, as we have repeatedly discussed the need for a 5-10% correction to resolve the overbought and extended conditions. While we have previously suggested that we though such a correction may occur later in the summer, we may be in the process now.

Manage your risks accordingly.

The Deficit Is Misleading

The federal deficit is massive and growing too rapidly. It is obscene, whether you measure it in absolute terms or as a percentage of GDP. This is one crucial factor that warrants concern for bond investors and keeps yields higher than they should be.

However, deficit analysis is complicated. Our latest article, Interest Rates Are Too High, helps ease some concerns about the deficit. It is essential to consider the effect of higher interest rates on the deficit and the circular relationship between rates and the deficit. Fears over high deficits keep interest rates high, which adds to deficit spending. To explain, consider the first graph below. It shows that over $500 billion of the recent annual deficit is solely a function of higher interest expenses. However, on the bright side, lower interest rates will lower government spending, easing bond investors’ concerns. As we wrote:

Assuming no significant changes to the rate of government spending, deficits will fluctuate with interest rates. Therefore, in a circular fashion, when interest rates fall, the market’s fear of fiscal deficits will likely lessen.

The second graph helps put context to the deficit sans interest expenses. To wit:

The graph below puts the deficit and interest expenses into context. It shows deficits, sans interest expenses, as a percentage of GDP. The recent peak, 5.71%, is historically high, but notice the deficit spending of the financial crisis and pandemic-related stimulus dwarf it. Further, last quarter’s peak is not far from the 2016 and 2018 highs when spending was not generally considered out of control.

Capital One Paints A Mixed Picture Of The Consumer

Capital One is a good barometer for the financial health of the average consumer as they are a large retail bank and credit card company. Its earnings report on Wednesday paints a mixed picture. Regarding consumer savings, Richard Fairbank, Capital One’s CEO, appears optimistic. To wit:

“When we look at our customers, we see that on average, they have higher bank balances than before the pandemic, and this is true across income levels….on the whole, I’d say consumers are in reasonably good shape relative to most historical benchmarks”

However, while consumers, at least those with Capital One Bank accounts, seem to have relatively substantial savings on average, Capital One’s credit card division is worried about growing losses. The following figures indicate they are building their financial buffer to protect against increasing credit card losses.

• Provision for credit losses increased $1.2 billion to $3.9 billion
• Net charge-offs of $2.6 billion
• $1.3 billion loan reserve build

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Making sense of home sales and prices data is challenging as there is little activity in the real estate markets. High mortgage rates have made it difficult for buyers to buy homes. Accordingly, more would-be sellers are unable or unwilling to sell because they do not want to trade their current low mortgage rate for a much higher one with a new home.

The latest data from the National Association of Realtors (NAR) shows existing home sales fell in June to a seasonally adjusted annual rate of 3.89 million homes. On a non-seasonally adjusted rate, it was 375k, the lowest level in June going back to 1999. The prior low was in June of 2008. The median home price rose 4.1% to $426,900. There is some hope for homebuyers that home price growth may slow. The inventory of unsold existing homes rose to 4.1 months of supply. Furthermore, June marks the end of the buying season. As shown below, existing home prices (blue) often decline as the buying season ends. The Chief Economist from the NAR sees the potential for a buyer’s market to emerge as home prices potentially moderate. Per the latest NAR report.

“We’re seeing a slow shift from a seller’s market to a buyer’s market,” said NAR Chief Economist Lawrence Yun. “Homes are sitting on the market a bit longer, and sellers are receiving fewer offers. More buyers are insisting on home inspections and appraisals, and inventory is definitively rising on a national basis.”

What To Watch Today

Earnings

Economy

Market Trading Update

As noted yesterday, market breadth has improved recently, which provides support for a continued bullish rally. The recovery of the 20-DMA and the drop in the VIX also support a continued bull market for now. However, this does not negate the potential for a 5-10% correction later this summer heading into the election. As shown, during presidential election years, the markets tend to de-risk a bit before the election simply due to the risk of the outcome.

Could this year be different? This is why it is important to maintain exposure for now and continue to manage risk as needed.

There are plenty of reasons to be very concerned about the market over the next few months. We suggest using rallies to reduce equity exposure and hedge risks accordingly.

1. Move slowly. There is no rush to make dramatic changes. Doing anything in a moment of “panic” tends to be the wrong thing.
2. If you are overweight equities, DO NOT try to fully adjust your portfolio to your target allocation in one move. Individuals often feel like they “must” do something. Think logically about where you want to be and use a rally to adjust to that level.
3. Begin by selling laggards and losers. These positions were dragging on performance as the market rose, they tend to lead on the way down.
4. Add to sectors or positions performing with or outperforming the broader market if you need risk exposure.
5. Move “stop-loss” levels up to recent lows for each position. Managing a portfolio without “stop-loss” levels is like driving with your eyes closed.
6. Be prepared to sell into the rally and reduce overall portfolio risk. You will sell many positions at a loss simply because you overpaid for them to begin with. Selling at a loss DOES NOT make you a loser. It just means you made a mistake.
7. If none of this makes sense to you, please consider hiring someone to manage your portfolio. It will be worth the additional expense over the long term.

Follow your process.

Small Caps Have Potential, But…

Many investors are starting to think small-cap and value stocks may finally be in vogue. The rotation from large-cap growth to those sectors was certainly eye-opening these past few weeks. Before jumping into the small-cap value camp, consider the important differences between the two indexes.

The BofA graph below, courtesy of ISABELNET.com, shows the price ratio of large-cap growth versus small-cap value stocks. Excluding the sharp drawdown in the ratio in 2020, large-cap growth stocks have consistently outperformed small-cap value stocks since the end of the financial crisis. Generally, large-cap and growth stocks outperform during periods of economic growth. Conversely, small-cap and value stocks outperform during recessions. Not surprisingly, valuations tend to expand during economic growth and contract during recessions. Therefore, much attribution for the recent gross outperformance of large-cap growth versus small-cap value can be attributed to the type of stocks the two indexes hold.

The second graph compares the holdings by sector of popular ETFs tracking large-cap growth (IVW) and small-cap value (IJS). As shown, technology accounts for a big difference between the two ETFs. It represents 50% of IVW and slightly less than 10% of IJS. Conversely, financials are only 5% of IVW but 28% of IJS. The point of showing these stark differences is that the price ratio graph may not revert to normal, as some investors appear to believe. Simply put, the massive differences in the type of stocks, growth patterns, and valuations of said stocks should lead to long-term performance differences. Those differences may get extreme sometimes, but correcting to the average is far from a foregone conclusion.

A Crude Oil Breakout Is Likely

For the past year, the price of crude oil has been forming a wedge pattern. The pattern, as shown below, is a series of lower highs and higher lows that is increasingly becoming less range-bound. Often, such a pattern ultimately resolves itself with a sharp move. The question is, what direction? Further signs of a slowing economy may mean that the resolution of the pattern will result in lower oil prices. Political or geopolitical concerns could also dictate the breakout.

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As we shared in a recent Daily Commentary about interest rates:

The current unemployment rate is 4%, and the core PCE inflation rate is 2.6%. In December 2019, the unemployment rate was 3.6%, and the core PCE was 1.6%. At the time, Fed Funds were 1.5%. Here we sit today, with the unemployment rate .4% higher and core PCE 1% higher than in 2019. Yet, the Fed Funds rate is 4% more than in 2019. Does it seem a bit high?

Nine months ago, we discussed some factors keeping yields above what we believe is their fair value. To wit, we ended Bond Market Noise, with the following statement:

The noise in the bond market is thunderous these days as inflation is still well above norms, deficits remain high, and the Fed continues to promise higher rates for longer. Noise creates differences between the yield on bonds and their true fair value.

Noise is hard to ignore, but it can create tremendous opportunities!

Neither the Commentary nor the article discussed R Star as a culprit behind higher yields. Therefore, given some recent mentions of R Star by Fed members, it’s worth adding to our prior analysis by diving into this wonky economics topic.

Before discussing R Star, we will update you on inflation and deficits, the two factors keeping yields high, as discussed in Bond Market Noise.  

Inflation

In our opinion, the primary reason that yields are too high is a pronounced fear from the Fed and bond investors of another round of inflation. The Fed runs an extraordinarily tight monetary policy to ensure it doesn’t reoccur. Investors are demanding a premium on yields to help protect against said fear.

In Bond Market Noise, we shared the best predictor of long-term yields, the Cleveland Fed Inflation Expectations Index. As shown below, the index, using current, surveyed, and market implied inflation is extremely correlated with ten-year Treasury yields.

Since we published the graph, the Cleveland Fed index has fallen by 0.01%, while the yield on the ten-year Treasury is down by .35%. The extreme yield differential that existed when we wrote the article has normalized somewhat. However, the model’s fair value ten-year yield is about .40% below current yields.

If the disinflation trend resumes, as seems increasingly likely, the Cleveland Fed index will likely decline. Every basis point decline in the index results in a 2.75 basis point decline in the model Treasury yield. Therefore, a substantial yield decrease is plausible if the index returns to the pre-pandemic average. Furthermore, a recession could push the index and model yields much lower.

Such may sound absurd given where yields are and what we have experienced over the last few years, but the ten-year yield was 0.50% not so long ago.

Deficits

Federal deficits are running larger than average, causing a bearish skew of Treasury debt supply versus investor demand. The imbalance is partially due to an extra $500 billion yearly in interest expenses, almost entirely due to higher interest rates. Of course, significant deficit spending is also responsible.  

Assuming no significant changes to the rate of government spending, deficits will fluctuate with interest rates. Therefore, in a circular fashion, when interest rates fall, the market’s fear of fiscal deficits will likely lessen.

The graph below puts the deficit and interest expenses into context. It shows deficits, sans interest expenses, as a percentage of GDP. The recent peak, 5.71%, is historically high, but notice the deficit spending of the financial crisis and pandemic-related stimulus dwarf it. Further, last quarter’s peak is not far from the 2016 and 2018 highs when spending was not generally considered out of control.

We are not trying to minimize the deficits in how we present the data. However, proper consideration is warranted since interest rates substantially impact deficits and debt issuance.

The Mythical R Star

Now, let’s dig into the economic textbooks and share a third reason: yields are higher than expected.

R Star is the real neutral rate of interest that balances the economy. It guides the Fed on how much of a headwind or tailwind their interest rate policy impacts the economy. The problem is that R Star is mythical. There is no definitive R Star. Hence, managing interest rates for the Fed is based on a guessing game of R Star.

Some economists and bond investors believe the R Star has increased over the past four years due to the pandemic. Thus, bond yields should be higher if R Star or the natural economic growth rate has increased.

The first graph below, courtesy of the New York Fed, shows two similar R Star models the Fed relies upon. The second graph charts them together with their trend lines.

As you can see, the two model rates fluctuate, but both have a decidedly lower trend. The Laubach-Williams model (blue) shows that the R Star is 1.18%, while the Holston-Laubach-Williams model (orange) is 0.70%. Assuming the Fed’s 2% target rate is the “stable inflation rate,” the models would argue an appropriate Fed Funds rate is between 2.70% and 3.18%. Currently, the rate is 5.25-5.50%.

Also noteworthy is that the trend lines imply that the R Star will decline by roughly .06% yearly.

Those bearish bond investors who think R Star will trend higher must believe the economic growth rate will reverse its trend of the last 40+ years.

Fed President Williams on R Star

We appreciate the argument that AI can be significant but are not sure we buy into how it affects economic productivity. Furthermore, demographics and massive outstanding unproductive debt will likely detract from economic growth in the future. 

In a recent speech, New York Fed President John Williams stated his case against a new upward trend in R Star.

“Although the value of R Star is always highly uncertain, the case for a sizable increase in R Star has yet to meet two important tests.“

The first is the “interconnectedness” or the R Star in other developed countries. There is no evidence that R Star is rising in Europe, China, or Japan.

“Second, any increase in R Star must overcome the forces that have been pushing R Star down for decades.“

Have productivity and demographics suddenly changed for the better? Again, there is no evidence that this is happening.

Lastly, we share a graph from Irrational Exuberance Then and Now.

Despite the internet and technology boom of the late 1990s and beyond, the economic and corporate earnings growth rate did not increase. In fact, as shown below, the economy grew at an average rate of nearly 3% from 1975 to 1999. Since then, the average growth rate has been closer to 2%. 

Summary

Suppose you think rates have reversed their downtrend of the last forty years and will reside at current levels or even higher. In that case, you must believe something significant has materially changed with the economy. The pandemic and the associated stimulus provided a roller coaster of economic activity, creating an economic mirage, but have the primary factors driving growth changed?

We say no and thus believe that interest rates still have plenty to decline alongside the mythological R Star.

We noted last Friday that over the previous few years, a handful of “Mega-Capitalization” (mega-market capitalization) stocks have dominated market returns and driven the bull market. In that article, we questioned whether the dominance of just a handful of stocks can continue to drive the bull market. Furthermore, the breadth of the bull market rally has remained a vital concern of the bulls. We discussed that issue in detail in “Bad Breadth Keeps Getting Worse,”

“While the market is making all-time highs as momentum continues, its breadth is narrowing. The number of stocks trading above their respective 50-DMA continues to decline as the market advances, along with the MACD signal. Furthermore, the NYSE Advance-Decline line and the Relative Strength Index (RSI) have reversed, adding to the negative divergences from a rising market. While this does not mean the market is about to crash, it does suggest that the current rally is weaker than the index suggests.“

Since the beginning of this year, the “bad breadth” issue has been a concern for the current bull market rally. Such is because, historically speaking, periods of narrow market advances typically precede short-term corrections and bear markets. As Bob Farrell once noted:

“Markets are strongest when broad, and weakest when narrow.”

However, as the Federal Reserve prepares to cut rates for the first time since 2020, there seems to be a change afoot. Following the most recent Consumer Price Index (CPI) report, there was an evident rotation from the previous market leaders to the laggards. More importantly, the breadth of the market has improved markedly, with the NYSE Advance-Decline hitting all-time highs. Furthermore, the previous negative divergences in the Relative Strength Index (RSI) and the number of stocks above their 50-DMA also reversed higher.

What does that mean?

“The market action as of late has been refreshing and could be the sign of a maturing bull market, where a wide range of stocks are contributing to the rally, providing more support for stock indexes at record levels.” – Yahoo Finance

Historically, improving breadth suggests that the bull market’s health is improving. However, while breadth has undoubtedly improved, with the bulls encouraged by the prospect of Federal Reserve rate cuts, is the recent broadening of the market sustainable? Maybe. However, as Sentiment Trader recently noted:

“After more than a month of meaningful divergences between indexes and individual stocks, those were largely resolved in a historic shift late last week. While a new high in cumulative breadth has been a positive long-term sign, returns were more questionable in the shorter term when the S&P 500 had far outpaced market-wide breadth.”

In this particular case, we agree. There are risks to this current rally in small-cap stocks worth understanding.

Risks To The Russell

With the Fed cutting rates and the prospect of a pro-growth, tax-cut, and tariff-friendly President, it is unsurprising to see narratives about why the market rally will broaden with Small and Mid-capitalization companies taking leadership.

However, while such could be the case, many problems still plague these companies. As we noted in this past weekend’s Bull Bear Report:

First, nearly 40% of the Russell 2000 is unprofitable.

“However, some issues also plague smaller capitalization companies that remain. The first, as noted by Goldman Sachs, remains a fundamental one.

“I’m surprised how easy it is to find someone who wants to call the top in tech and slide those chips into small cap. Aside from the prosect of short-term pain trades, I don’t get the fundamental argument for sustained outperformance of an index where 1-in-3 companies will be unprofitable this year.”

As shown in the chart by Apollo below, in the 1990s, 15% of companies in the Russell 2000 had negative 12-month trailing EPS. Today, that share is 40%.”

Besides the apparent fact that retail investors are chasing a rising slate of unprofitable companies, these companies are also heavily leveraged and dependent on debt issuance to stay afloat (a.k.a. zombies.) These companies are susceptible to actual changes in the underlying economy.

With a slowing economy, these companies depend highly on the consumer to generate revenues. As consumption decreases, so does their profitability, which will weigh on share performance. Such was a point made by Simon White via Bloomberg last week:

“The yield curve based on inflation expectations has flattened significantly and is now more inverted than it ever has been – and it will remain under pressure in the event of a Trump presidential victory. This “expectations curve” shows that consumers are anticipating much tighter financial conditions than inferred by the market via the nominal yield curve, presenting a risk to consumption, broader economic growth and equity valuations and returns.“

Furthermore, the companies in the Russell 2000 (a good proxy for small- and mid-capitalization companies) do not have the financial capital to execute large-scale buybacks to support asset prices and offset slowing earnings growth by reducing share count. As we noted previously, since 2000, corporations have been the sole net buyers of equities, which has created a substantial outperformance over time by large capitalization stocks.

However, while the rally’s breadth has improved, those headwinds may substantially challenge the bull market’s sustainability.

Breadth Has Improved, But Is it Enough?

A market rally needs buyers to be sustainable.

If the current rotation were occurring from a deeply oversold condition following a broader market correction, I would be a stronger believer in its sustainability. However, as we have noted previously, investors (both retail and professional) are exceptionally bullish.

Furthermore, with that bullish sentiment, investors are fully allocated to equities. The chart below shows the average equity allocation of both retail and professional investors. Historically, readings above 80 are associated with near-market peaks. The current reading is 87, which is in more rarefied air.

Given the more aggressive equity allocation levels, which also translates into low cash levels, the ability to take on more exposure to continue to boost the market higher is somewhat questionable.

Lastly, while the market sentiment is bullish, we are beginning to see some early cracks in the credit market. Historically, when credit spreads start to widen, such has preceded a rise in market volatility. As shown, the yield spread on junk bonds is rising again. While early, such increases between CCC-rated and B-rated corporate bonds have been an early warning sign of market stress.

Yes, the market could continue to rotate massively from large-cap to small and mid-capitalization companies. However, given the current levels of bullish sentiment and allocations against a backdrop of weakening economic data and widening spreads, this suggests the current rotation may be nothing more than a significant short-covering rally. Furthermore, the current technical overbought and extended conditions also suggest sustainability remains questionable.

With investors already heavily allocated to equities, the question remains: “Who is left to buy?”

Furthermore, the risk remains with a broader market correction heading into the election. Such would likely impact large and small-cap companies.

As Yahoo suggests, could this be the start of the real bull market?

Of course, markets can always do the unexpected. If the rotation continues and the economic backdrop improves markedly, supporting earnings growth, we will modify our portfolios accordingly.

It is possible.

However, we will remain in our portfolio management process’s “show me” phase until the market convinces us differently.

To show the dramatic shift in market breadth, we compare the SimpleVisor Absolute/Relative sector and factor analysis from yesterday to one month ago. The top graphs show that technology (XLK) was the only sector with a positive absolute and relative score a month ago. Today, every sector except technology has a positive absolute score, and most have positive relative scores. Consequently, XLK is now the most oversold sector. The factor graphs are similar. A month ago, S&P 500 growth (IVW) and Momentum (MTUM) were the only factors overbought on an absolute and relative basis. Today, MTUM is the most oversold factor when using both measures. IVW is close to fair value.

The two important takeaways are the massive market rotation from large cap and tech to small cap and value and the improving breadth. Regarding the market breadth, note in both graphs how much closer every sector and factor is to each other. This grouping tells us the sectors and factors are more aligned technically than they were. However, the market’s breadth could worsen if the rotation toward value and small caps continues. Furthermore, it could revert to prior conditions.

What To Watch Today

Earnings

Economy

Market Trading Update

Well, that didn’t take long. As we noted yesterday, small caps dominated the market last week. However, that changed on Monday, with the “Mega-caps” stocks roaring back to life and volatility dropping sharply. Such is seen in the market’s heat map.

The quick return to the previous leaders is not surprising. As we discussed in yesterday’s post, “Can Mega-Caps Continue Their Dominance,” nothing has derailed that trade currently. These stocks provide a lot of liquidity for portfolio managers and hedge and pension funds. They also provide the bulk of earnings growth for the entire market. Furthermore, they are the biggest buyers of their shares.

The good news is that the market regained the 20-DMA, which negates the break on Friday. So far, this is a successful retest of support and suggests the bullish trend remains intact. With volatility declining, a return to previous market highs would be unsurprising. However, the market remains on a short-term MACD “sell signal,” which may limit any upside to the market in the near term. Given that we took profits out of holdings last week, there is not much we need to do currently. However, we are watching closely for any further cracks that suggest a corrective process is continuing.

Lithium Prices Languish

Mining.Com wrote a telling article about the state of lithium and lithium producers- With no recovery in sight, lithium prices force miners to reevaluate output. The article talks about the growing glut of lithium in the market. The first graph below shows an expectation that the lithium supply will exceed the demand until 2029. As a result, lithium prices are declining alongside the share prices of lithium producers, as we share in the second and third graphs.

While the article depicts a case for lower lithium prices, it also points to an important factor that may argue against that. Specifically, as lithium prices fall, so does the profitability of lithium miners. Consequently, they invest less in future production to help bring supply back into balance. Per the article:

A prolonged period of low lithium prices could “trigger a renewed wave of mine supply cuts and project delays,” said Alice Yu, the lead metals and mining research analyst at S&P Global Commodity Insights.

The article offers that coming earnings reports may guide how miners are reacting to the supply glut.

Clearer indications of the intentions of some top miners may be revealed in the coming weeks with the release of quarterly production reports or earnings. The insights from Pilbara Minerals Ltd., Mineral Resources Ltd., Albemarle Corp. and Arcadium Lithium Plc may provide clues on what the supply response might look like.

Yield Curve Update

The Treasury 2-10-year yield curve has been inverted for over two years. Such is the longest since at least 1975. The graph shows that the un-inversion of inverted yield curves preceded the last four recessions by 6-18 months. However, the uninversion coincided with the onset of the two prior recessions. The yield curve is off its lows but remains inverted near levels seen before the 1990, 2000, and 2008 recessions. Hence, we need to ask ourselves whether the yield curve will uninvert.

The answer is primarily dependent on the Fed. If the market starts pricing in more aggressive rate cuts and the Fed does indeed cut rates, the yield curve would most likely uninvert. Consequently, the Fed and investors would take the odds of a recession more seriously.

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Over the five trading days ending July 16, the small-cap Russell 2000 Index (IWM) had its largest five-day outperformance versus the S&P 500 (SPY) since the two ETFs started trading in 2000. In just five days, IWM beat SPY by nearly 10%. Despite the recent outperformance, the S&P 500 is still beating small caps by over 8% year to date. Therefore, the critical question for investors is what comes next. Might small-cap stocks continue to outperform in the coming weeks and possibly months? Also, do large-cap stocks continue to outperform as they have done all year? To answer the question, we created the table below.

The table shows the top 11 five-day periods of small-cap outperformance over large-cap stocks, including the recent period. In addition to the 5-day excess returns, we also show the relative performance of small caps versus large caps over the next 20, 50, and 100 days. On average, the small-cap index tends to slightly underperform the market after outperforming. However, there is a wide range of outcomes, as shown by each experience and the minimum and maximum excess returns for each forward return period.

What To Watch Today

Earnings

Economy

Market Trading Update

Last week, we noted that the market did flip the previous “sell signal,” with stocks topping 5600 for the first time. However, that move also pushed the market back into extremely overbought territory, and the deviation from the 50-DMA is quite significant. As noted:

“Such suggests that, as we saw in late May and June, the market will either consolidate or correct back to the 20-DMA. If the bulls can hold that level again, as they have, the market could continue to push higher. Such is possible given the current exuberance surrounding the Fed cutting rates. However, if the 20-DMA fails, as in early April, the 50-DMA becomes the next logical support, with the 100-DMA close behind. Such would encompass another 3-5% correction.“

On Friday, the market broke the 20-DMA and flipped the MACD indicator back onto a short-term “sell signal.” While we will likely see a rally early next week, a failure to close above the 20-DMA may suggest a further correction to the 50-DMA. A further correction is possible with the market oversold and triggering a fresh sell signal. Those triggers led us to take profits out of several positions this past week to hedge against a further decline. We will raise cash levels further if technical deterioration continues.

The big story this past week was the rapid rotation from the “Mega-cap” stocks to the Russell 2000. That rotation surprised many managers, leading to a rapid de-risking of portfolios. To wit:

“The de-grossing activity over the past 5 sessions is the largest since Nov ’22 and ranks in the 99th percentile on a 5-year lookback.”

While the short-term rotation could continue, we suspect that it will eventually revert back to the large-cap stocks as the economy continues to slow. There are several reasons for this.

1. Large caps are generating earnings growth to support valuations, whereas small caps are not.
2. Portfolio managers will hide in highly liquid large capitalization companies.
3. 40% of the Russell 2000 is non-profitable, and earnings depend highly on a growing economy.
4. Small and Mid-cap companies can not execute buybacks on scale.
5. Large capitalization companies continue to benefit from passive investing ETFs, whereas Russell 2000 does not.

While it is certainly possible for a sustainable rotation to occur, the many headwinds facing the market into the end of this year suggest there is more risk than not.

The Week Ahead

The number of quarterly earnings reports will expand as we enter the heart of earnings season. However, many of the largest cap stocks and Magnificent Seven members will report next week. But Google and Tesla will report their earnings on Tuesday.

The economic calendar heats up later this week, with GDP on Thursday and PCE prices on Friday. The consensus is for 2% economic growth in the second quarter. The Atlanta Fed GDPNow is forecasting 2.7% growth for the quarter. Also of importance for the Fed will be the PCE prices index. As we saw with CPI, a negative number could warrant an unexpected ease at the July 31 meeting. The current estimate is for a 0.1% increase.

The Fed will be quiet this week as it goes on a media blackout ahead of the FOMC meeting on July 30-31.

CrowdStrike and Microsoft Have A Massive Glitch

CrowdStrike shares opened lower by nearly 15% on Friday morning as the cybersecurity company took the blame for a glitch that created widespread internet outages. The glitch was due to a software update and affected many services hosted on the Microsoft cloud platform. It appears the outage most affected the airline industry. Per NBC News, the glitch caused nearly 1400 flight delays and cancelations. Furthermore, is the following from their article on the subject:

Major carriers, including American Airlines, Delta Air Lines and United Airlines, all issued ground stops Friday morning citing communications issues. Passengers traveling to the United States from as far away as Japan have had their flights canceled. Delta has ordered a “global ground stop,” said Rep. Eric Swalwell, a member of the House subcommittee on cybersecurity.

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On Wednesday, the Nasdaq fell by nearly 3%, the most significant decline in over two years. However, the Dow, representing more value stocks, was up over half a percent and set a record high. If the recent rotations out of technology, communications, and the largest market-cap stocks continue, the broad S&P 500 and the Nasdaq will likely decline. However, might the small cap, medium cap, and value stocks that have been lagging considerably do well? Conversely, might this stock rotation be a healthy pause in the uptrend, allowing the unsustainable breadth to normalize?

We use SimpleVisor to help us appreciate the performance of stock factors and sectors over the last ten trading days and the 60 days prior. The first graphics show stock factors and sectors’ excess returns versus the S&P 500. Simply, what underperformed in the prior 60 days (red) is outperforming in the last two weeks, and vice versa.

The lower graphic charts the price of the Russell small cap index (IWM) divided by the price of the Nasdaq (QQQ). Below the price ratio graph, SimpleVisor applies a few technical models. All three have recently flipped to a buy signal favoring IWM to QQQ. However, they have triggered similar buy signals in the past two years, which resolved themselves in consolidation, not meaningful IWM outperformance. Time will tell if this stock rotation is lasting.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday’s update discussed the many sectors and markets trading well above their monthly risk/reward ranges. In particular, Gold and Gold Miners are trading at double-digit deviations from their long-term moving averages. Historically, when Gold, and by extension Gold Miners, are well deviated above their longer-term moving averages, as they are now, it has been a good opportunity to take profits and rebalance risk.

Gold has had an excellent move over the last few years, but with the MACD indicator very elevated, such suggests that performance may start to lag. Such does not mean that the price of gold will crash. However, as we saw in 2020, gold may go into a long period of consolidation where other assets perform better. As always, gold is a commodity with no fundamentals or dividend. The commodity traders on the exchanges solely determine its price. Therefore, from a risk management perspective, manage your position size accordingly and take profits as needed.

The Rising Unemployment Rate Is Signalling Trouble

The unemployment rate is a lagging economic indicator. Often, it doesn’t rise materially until a recession has started. This is important because one of the Fed’s mandated objectives is maximum employment. Per the Federal Reserve Act:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

The graph below shows the six-month change in the unemployment rate of 16-24 year olds. Many of these job holders are in economically sensitive areas. As such, the employment trends in this age group tend to lead the broader employment data. The graph shows where the change in the unemployment rate for 16-24-year-olds was between two years before the last six recessions and two years after it started. The current rate is higher than the onset of the previous six recessions. The Fed may be worried that this graph and other labor indicators warn the Fed they have left Fed Funds too high for too long.

Update On Jobless Claims

The importance of jobless claims is not what it used to be, as jobless claims benefits have not kept up with wages. Many recently fired employees can make much more money doing part-time or gig-economy jobs. While the absolute number of claims may not be comparable to the past, the trend is still noteworthy.

Jobless claims for the week were +243k, which is near a one-year high. A better measure of the health of the labor market is continuing or longer-term claims. This week’s 1.87 million longer-term jobless claims is the highest weekly figure since November 2021. This is a decent increase from the 1.847 million reported last week. However, while the trend is becoming concerning, anything less than 2 million longer-term jobless claims is consistent with a healthy labor market.

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Over the last few years, a handful of “Mega-Capitalization” (mega-market capitalization) stocks have dominated market returns. The question is whether that dominance will continue and if the same companies remain the leaders. It is an interesting question. The number of publicly traded companies continues to decline, as shown in the following chart from Apollo.

This decline has many reasons, including mergers and acquisitions, bankruptcy, leveraged buyouts, and private equity. For example, Twitter (now X) was once a publicly traded company before Elon Musk acquired it and took it private. Unsurprisingly, with fewer publicly traded companies, there are fewer opportunities as market capital increases. Such is particularly the case for large institutions that must deploy large amounts of capital over short periods. With nearly 40% of the companies in the Russell 2000 index currently non-profitable, the choices are limited even further.

However, this period’s concentration of market capitalization into a few names is not unique. In the 1960s and 1970s, it was the “Nifty 50.” Then, in the late 90s, it was the “Dot.com” darlings like Cisco Systems. Today, it is anything related to “artificial Intelligence.”

As shown, the leaders of the past are not today’s leaders. Notably, Nvidia (NVDA) will get added to the list of the largest “mega-cap” companies for the first time in 2024.

However, investors must decide whether Microsoft, Apple, Google, and Amazon will remain the leaders over the coming decade. Just as AT&T and GM were once the darlings of Wall Street, today’s Technology shares may become relics of the past.

Earnings Growth

One primary determinant in answering that question is earnings growth. As should be obvious, investors are willing to pay higher prices when corporate earnings are growing.

The problem is that in 2023, all the earnings growth came from the index’s top-7 “mega-capitalization” stocks. The S&P 500 would have had negative earnings growth excluding those seven stocks. Such would have likely resulted in a more disappointing market outcome. Notably, while analysts are optimistic that earnings growth for the bottom 493 stocks will accelerate into the end of 2024, with economic data slowing, those hopes will likely be disappointed.

Over the next decade, companies like Microsoft, Apple, and Alphabet will face the challenge of growing revenues fast enough to keep earnings growth rates elevated. Given that Nvidia is a relatively young company in a fast-growing industry, it has been able to increase revenues sharply to support higher valuation multiples.

However, Apple, a very mature company, cannot grow revenues at such a high rate. Such is simply because of the law of large numbers. I have included a 5-year annualized growth rate of revenues to illustrate the issue better.

That is where the Wall Street axiom “Trees don’t grow to the sky” comes from.  

In investing, it describes the danger of maturing companies with a high growth rate. In some cases, a company with an exponential growth rate will achieve a high valuation based on the unrealistic expectation that growth will continue at the same pace as the company becomes larger. For example, if a company has $10 billion in revenue and a 200% growth rate, it’s easy to think it will achieve 100s of billions in revenue within a few short years.

However, the larger a company becomes, the more difficult it becomes to achieve a high growth rate. For example, a firm with a 1% market share might quickly achieve 2%. However, when a firm has an 80% market share, doubling sales requires growing the market or entering new markets where it isn’t as strong. Firms also tend to become less efficient and innovative as they grow due to diseconomies of scale.

For this reason, many of today’s top market capitalization-weighted stocks may not be the same in a decade. Just as AT&T is a relic of yesterday’s “new technology,” such may be true with Apple a few years from now when no one needs a “smartphone” anymore.

Passive Investing’s Impact

Over the last two decades, the rise of passive investing has been another interesting change in the financial markets. As discussed previously, the top-10 “mega-capitalization” stocks in the S&P 500 index comprise more than 1/3rd of the index. In other words, a 1% gain in the top 10 stocks is the same as a 1% gain in the bottom 90%. As investors buy shares of a passive ETF, the ETF must purchase the shares of all the underlying companies. Given the massive inflows into ETFs over the last year and subsequent inflows into the top 10 stocks, the mirage of market stability is not surprising.

Unsurprisingly, the forced feeding of dollars into the largest weighted stocks makes market performance appear more robust than it is. That is also why the S&P 500 market-capitalization weighted index has outperformed the equal-weighted index over the last few years.

Investors often overlook this double-edged sword. For example, let’s assume that Tesla was 5% in the S&P 500 index before Nvidia entered the top 10. As Nivida’s rapid share price increased its market capitalization, Tesla’s was reduced as its stock price fell. Therefore, all index funds, passive fund managers, portfolio managers, etc., had to increase their weightings in Nvidia and reduce their ownership in Tesla.

In the future, whatever the next generation of companies garners Wall Street’s favor, the current leaders could fall out of the top 10 as the “passive” flows require additional selling of today’s leaders to buy more of tomorrow’s.

Share Buybacks

Lastly, corporate share buybacks, expected to approach $1 trillion and exceed that in 2024, could weigh on current leadership. That is because the largest companies with the cash to execute large multi-billion dollar programs, like Apple, Microsoft, Alphabet, and Nvidia, dominate buybacks. For example, Apple alone will account for over 10% of 2024 buybacks.

If you don’t understand the importance of share buybacks in maintaining the largest companies’ current market dominance, here is some basic math.

• Pensions and MF = (-$2.7 Trillion)
• Households and Foreign = +$2.4 Trillion
  • Sub Total = (-$0.3 Trillion)
• Corporations (Buybacks) = $5.5 Trillion
  • Net Total = $5.2 Trillion

In other words, since 2000, corporations have provided 100% of all the net equity buying.

Therefore, it should be unsurprising that there is a high correlation between the ebbs and flows of corporate share buybacks and market performance.

Therefore, as long as corporations remain the top buyers of their shares, the current dominance of the “Mega-caps” will continue. Of course, there are reasons the current rate of corporate share repurchases will end.

• Changes to the tax code
• A ban on share repurchases (they were previously illegal due to their ability to manipulate markets)
• A reversal of profitability, making share repurchases onerous.
• Economic recession/credit event where corporations go on the defensive (i.e., 2000, 2008, 2022)

Whatever the reason, the eventual reversal of buyback programs could severely limit the current leader’s market dominance.

I have no clue what event causes such a reversal or when. However, a reversal could undo mega-cap dominance since corporate share buybacks have provided all the net equity buying for the largest stocks.

Conclusion

The current dominance of the largest “Mega-capitalization” companies is unsurprising. As noted, they make up the bulk of earnings growth and revenues of the S&P 500 index, the largest purchasers of their shares. These are also the same companies in the middle of the current “Artificial Intelligence” revolution, as has been the case for the last decade.

However, given the speed at which technology and the economy rapidly change, such suggests that leaders of the last decade may not be the leaders of the next.

As investors, it is vital to understand the dynamics of each market cycle and invest accordingly. However, those buying stocks today at some of the most extreme valuations we have seen over the last century and expecting those shares to dominate over the next decade could be disappointed.

Many variables support the current secular bull market cycle. However, as has been the case throughout history, a myopic approach to investing has led to poor outcomes.

Invest accordingly.

On Tuesday, we published Fed Rate Cuts – A Signal To Sell Stocks And Buy Bonds? The article presents a historical context for what investors can expect when the Fed cuts rates. Unlike the bullish sentiment prevailing around rate cuts, historical reality has not been so friendly to equity investors.

So what can we expect?

Given that historical perspective, it certainly seems apparent that investors should NOT anticipate a Fed rate-cutting cycle. There are several reasons why: 1- Rate cuts generally coincide with the Fed working to counter a deflationary economic cycle or financial event. 2- As deflationary or financial events unfold, consumer activity contracts, which impairs corporate earnings. 3- As corporate earnings decline, markets must reprice current valuations for lower earnings.

The article ends as follows:

Therefore, as we approach the first Fed rate cut in September, it may be time to consider reducing equity risk and increasing exposure to Treasury bonds.

We enhanced an important graph from the article to help answer the question- what can we expect? The original graph showed the maximum drawdowns of stocks during periods of Fed rate cuts. The graph below shows the total return of ten-year UST notes during the entire rate-cutting time frame alongside the equity drawdowns. While history doesn’t always repeat itself, an investor would have been much better off in bonds versus stocks during each of the last nine significant Fed Fund rate cuts. This time may differ, but history is not on your side.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday’s commentary discussed the more bullish setup that is forming in the bond market. As Michael notes above, when the Fed cuts rates, bonds have performed much better than stocks on average.

Each week in the #BullBearReport (Subscribe for free), we publish a Risk-Range report that examines the current price movement of major sectors and markets relative to their historical monthly norms. As shown below, many sectors and markets are currently trading well above those norms.

In particular, the S&P 500, Communications, Technology, Small Cap, Gold, and Gold Miners are trading above normal historical monthly ranges and sport double-digit deviations from their long-term moving averages. These double-digit deviations are not sustainable and will eventually lead to a correction or consolidation (like what technology is currently going through).

The last time I wrote about these double-digit deviations, it was concerning Gold and Gold miners, which were near the peak in mid-April. From that point, gold traded sideways and lower through mid-June before working off that condition. That extreme has now returned.

This analysis does not suggest that a major correction will occur. However, it is good for understanding when to take profits and reduce portfolio risk. That analysis suggests we are once again near that point.

Tangible Vs. Intangible Assets

The graph below, courtesy of the Visual Capitalist, speaks volumes about how the US economy and the S&P 500 have changed over the last 50 years. In the 1970s, the energy, industrial, and automotive sectors were the drivers of the economy. However, over time, it has shifted considerably from the manufacturing sector to the service sector. In 1975, only 17% of assets on corporate balance sheets were intangible. These included things like patents and goodwill. Today, those intangible assets, including customer data and software, account for 90% of corporate assets.

As this shift occurred, the traditional manufacturing industries fell in importance to the S&P 500. At the same time, technology and communications gained significant ground. Utilities, for instance, have an aggregate market cap of approximately $1.70 trillion. Apple is more than double that at $3.60 trillion.

Trump Warns Powell

According to the Financial Times, Donald Trump has told Powell not to cut interest rates before the election. If he obeys, Trump will let Powell serve his full term. Per Trump:

I would let him serve it out. Especially if I thought he was doing the right thing.

So, if elected, can Trump fire Powell? The answer is yes, but as shown below from the Federal Reserve Act, Trump would need a reason. Given the current state of the economy and slowing inflation, lowering interest rates is not a viable reason to fire Powell. While the election is still months away, we must wait to see if this is another idle threat toward Powell or if it has teeth.

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Goldman Sachs has been vocal over the last week or two, making a good case for the Fed to cut rates as soon as the July 31st FOMC meeting. Goldman Sachs strategist Jan Hitzius was quoted as follows:

While September remains our baseline, we see a solid rationale for already cutting in July. If the case for a cut is clear, why wait another seven weeks before delivering it?

The graph below also from Goldman Sachs shows that many monetary policy rules the Fed tracks imply that Fed Funds are, on average, about 1.25-1.50% too high. Moody’s seems to agree with Goldman Sachs. In a recent statement, they say:

The Fed could begin policy easing with a 25 basis point cut as early as in the upcoming 30-31 July meeting.

While we believe there is a good case for rate cuts, it still appears the Fed wants to wait for more economic data. Thus, a September hike is the most likely date for the first rate cut. However, history shows the Fed can change its mind quickly. In June 2019, the Fed said it would not cut rates until 2020. They lowered the Fed Funds rate in the following month (July).

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we discussed the small and mid-cap trade, which has become very extended and overbought very quickly. That performance rotation from large caps to the Russell 2000 index continued yesterday, spurred by a decline in interest rates.

The bond market has continued to improve technically for quite some time now. In contrast, many market participants continue to shun longer-duration bonds due to misguided information on how the bond market works. On a technical basis, the price action since October has been solidly bullish. Higher bottoms in price and a rising trend in relative strength suggest buyers are accumulating positions. Most notably, bond prices have cleared all their major moving averages and are trying to break above the current downtrend line.

As discussed yesterday, with expectations rising, the Federal Reserve will cut rates; the reduction of rates on the front end of the curve, along with slowing economic growth, historically precedes a decline in longer-duration bond yields.

While bond volatility has not ended, the bullish trend in bonds is beginning to take shape. As discussed in that article, the risk to investors may lie with the stock market as Fed rate cuts historically collide with slower economic activity and a reduction in earnings growth.

Retail Sales Are Weaker Than It Appears

Retail sales came in at 0.0%, which aligns with the consensus. Additionally, last month’s figure was revised from 0.1% to 0.3%. The data continue to point to weak personal consumption. The graph below from Charlie Bilello shows that retail sales are tracking well below the historical average. Further, they are down 1% on an inflation-adjusted basis. More troubling is the following quote from David Rosenberg:

If you were rubbing your eyes as I was over that retail sales report, I think I found the answer. A very generous seasonal adjustment factor was at play. The raw NSA data actually showed retail sales plunging -5.6% MoM in June, the worst drubbing in a decade and tied for the steepest plunge since the series began in 1992! Lies, damned lies, and statistics.

Advice From Howard Marks, A Value Investor

Passive investing is the rage these days, but active investment strategies exist and will likely thrive one day. As such, we thought we would share some of the logic of Howard Marks, one of the most successful value investors. Marks is the chairman and one of the founders of Oaktree Capital Management. Over his 40 years of investing experience, he has had much success. Furthermore, he shares his market and economic thoughts with the public. You can find 35 years of his archived Memos HERE.

The following are a few choice quotes from his book The Most Important Thing:

If we avoid the losers, the winners take care of themselves.

Understand the psychology of the investor- greed, fear, ego, biases, and envy.

The investor’s job is to take risks intelligently. Doing it well separates the good investor from the rest.

Markets swing like pendulums.

Without an accurate estimate of intrinsic value, any hope for consistent success as an investor is just that: HOPE.

Investment success doesn’t come from “buying good things,” but rather from “buying things well.”

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On December 5, 1996, Chairman of the Fed Alan Greenspan offered that stock prices may be too high, thus risking a correction that could result in an economic fallout. He wondered out loud if the market had reached a state of “irrational exuberance.”

Over the past few months, we have seen the same term, irrational exuberance, used to describe the current state of the stock market. To gain perspective on the future, let’s compare the market environment that prompted Greenspan’s comments to today. 

Irrational Exuberance

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy. –Alan Greenspan December 1996

The simple translation: Greenspan was apprehensive due to high stock valuations; therefore, a correction of stock prices could damage the economy. He didn’t want to be “complacent about the complexity of the interactions of asset markets and the economy.”

Let’s review a few graphs to appreciate Greenspan’s point of view.

In just two years, between 1994 and the day Greenspan uttered irrational exuberance, the S&P 500 had risen nearly 60%. Furthermore, from the 1990 recession trough to his speech, the S&P had climbed almost 250%. 

The economic recovery from the recession of 1990 kicked off the bull market. Further fueling the run were fabulous projections of how the budding World Wide Web, computers, and the powers of modern technology would result in outsized corporate profits and economic growth. Sound familiar?

With such lofty projections came immense speculation. Investors were willing to pay more for corporate sales and earnings due to higher growth prospects. In other words, valuations rose.

The first graph below shows the Shiller CAPE10 valuation stood at levels last seen in 1929 and were moderately higher than those at the peak of the Nifty Fifty Bubble. For more on the Nifty Fifty, check out our article Are The Magnificent Seven In A Bubble? Ask The Nifty Fifty.

Another valuation metric, Tobin’s Q ratio, uses a company’s assets’ market value and replacement value to determine if a stock is over or undervalued. A ratio greater than one means the market values the company more than the value of its assets. Therefore, a high reading implies expectations for above-average earnings growth. As shown, in 1996, the ratio was slightly higher than the Nifty Fifty Bubble peak but below the 1929 peak.

Was Greenspan Prescient?

Greenspan had ample reason to worry with higher stock prices and valuations at levels seen near the tops of the last two stock booms. His warning caused the market to stutter for a few weeks before continuing its climb higher. Between December 5, 1996, and the bull market peak three years later, in 2000, the S&P more than doubled, and its valuations far exceeded the lofty levels of 1996.

Keep in mind that despite Greenspan’s weariness of market conditions, he cut rates by 75 basis points in late 1998 over concerns related to the Long Term Capital Hedge Fund bankruptcy. His actions further fueled the market significantly higher.

From the market peak in August of 2000 to its low in 2003, the S&P 500 erased a big chunk of the post “irrational exuberance” gains. Those highs would not be seen again until 2013.

Today’s Exuberance

The recent performance of the S&P 500 is like that of the mid to late 1990s. Similarly, current valuation metrics are at or above those Greenspan feared in 1996.

Today’s AI narrative mirrors the enthusiasm for the internet and technology forecasts of the mid- to late 1990s. Investors seem assured that AI will make the economy much more productive. Therefore, corporate profits will boom, and the economy will flourish. Those companies at the heart of AI, like Nvidia, Google, and Microsoft, will experience growth that dwarfs market averages. Or so we are told.

While the AI narrative sounds excellent, reality and narratives are often quite different. Despite the internet and technology boom of the late 1990s and beyond, the economic and corporate earnings growth rate did not increase. In fact, as shown below, the economy grew at an average rate of nearly 3% from 1975 to 1999. Since then, the average growth rate has been closer to 2%. 

Corporate earnings have followed a similar path despite the internet’s benefits.

Lessons From An Irrational Market

The market will likely correct meaningfully, and valuations will normalize. This time is not different.

However, the timing of a correction is far from known. Mr. Market doesn’t care what you, we, or the Fed Chairman think of valuations and prices. The market is bigger than all of us and can have a mind of its own. High valuations, even if in already record territory, can go higher.

The market can stay irrational longer than you can stay solvent. John Maynard Keynes

Some in the bearish camp advise taking our chips off the table and not trying to pick the top. That may be prescient. However, it may be years too early, like Greenspan’s irrational exuberance advice.

Walking the tightrope between irrational exuberance and reality is complex. Therefore, appreciate the market for what it is. This bull market has no known expiration date. Active management, using technical and fundamental analysis along with macroeconomic forecasting, is crucial to managing the potential risks and rewards that lie ahead.  

Summary

We leave you with a contrarian thought. What if we are experiencing rational exuberance and AI is an economic game changer? What if current valuations aptly reflect enhanced economic growth? Such profits and wealth formation may allow us to service unproductive debts better. Accordingly, today’s haunting macroeconomic issues may fade into a glorious future.

No one knows what the future holds. But, there are tools allowing us to maximize the upside better and limit the downside. With such potential returns and drawdowns lurking on the horizon, active management may likely prove to be the best way to manage your investments.

With both economic and inflation data continuing to weaken, expectations of Fed rate cuts are rising. Notably, following the latest consumer price index (CPI) report, which was weaker than expected, the odds of Fed rate cuts by September rose sharply. According to the CME, the odds of a 0.25% cut to the Fed rate are now 90%.

Since January 2022, the market has repeatedly rallied on hopes of Fed cuts and a return to increased monetary accommodation. Yet, so far, each rally eventually failed as economic data kept the Federal Reserve on hold.

However, as noted, the latest economic and inflation data show clear signs of weakness, which has bolstered Jerome Powell’s comments that we are nearing the point where Fed rate cuts are warranted. To wit:

“Major indexes rose as Federal Reserve Chair Jerome Powell spoke to a House committee after his first day of congressional testimony on Tuesday inched the Fed closer to lowering interest rates. In his testimony this week, Powell pointed to a cooling labor market and suggested that further softening might be unwelcome.”

Following those comments, the financial markets cruised to new highs. This is unsurprising since the last decade taught investors that stocks rally when the Fed “eases” financial conditions. Since 2008, stocks are up more than 500% from the lows. The only exceptions to that rally were corrections when the Fed was hiking rates.

Given recent history, why should investors not expect a continued rally in the stock market when Fed rate cuts begin?

Fed Rate Cuts And Market Outcomes

One constant from Wall Street is that “buy stocks” is the answer no matter what the question. Such is the case again as Fed rate cuts loom. The belief, as noted, is that rate cuts will boost the demand for equities as yields on short-term cash assets fall. However, as Michael Lebowitz pointed out previously in “Federal Reserve Pivots Are Not Bullish:”

“Since 1970, there have been nine instances in which the Fed significantly cut the Fed Funds rate. The average maximum drawdown from the start of each rate reduction period to the market trough was 27.25%.

The three most recent episodes saw larger-than-average drawdowns. Of the six other experiences, only one, 1974-1977, saw a drawdown worse than the average.”

Given that historical perspective, it certainly seems apparent that investors should NOT anticipate a Fed rate-cutting cycle. There are several reasons why:

1. Rate cuts generally coincide with the Fed working to counter a deflationary economic cycle or financial event.
2. As deflationary or financial events unfold, consumer activity contracts, which impairs corporate earnings.
3. As corporate earnings decline, markets must reprice current valuations for lower earnings.

The chart below shows corporate earnings’ deviation from long-term exponential growth trends. You will note that the earnings deviation reverts when the Fed cuts rates. Therefore, while analysts are optimistic about earnings growth going into 2025, a Fed rate-cutting cycle will likely disappoint those expectations.

More interestingly, the worse the economic data is, the more bullish investors have become in their search for that policy reversal. Of course, as noted, weaker economic growth and lower inflation, which would coincide with a rate-cutting cycle, do not support currently optimistic earnings estimates or valuations that remain well deviated above long-term trends.

Of course, that valuation deviation directly resulted from more than $43 Trillion in monetary interventions since 2008. The consistent support of any market decline trained investors to ignore the fundamental factors in the short term. However, as the Fed cuts rates to stave off a disinflationary or recessionary environment, the collision of economic realities with optimistic expectations has tended to turn out poorly.

Time To Buy Bonds?

One asset class stands out as an opportunity for investors to shelter during a Fed rate-cutting cycle: Treasury bonds. Notably, we are discussing U.S. Government Treasury bonds and not corporate bonds. As shown, during disinflationary events, economic recessions, and credit-related events, Treasury bonds benefit from the flight to safety, while corporate bonds are liquidated to offset default risks.

As stock prices fall during the valuation reversion proceeds, investors tend to look for a “safe harbor” to shelter capital from declining values. Historically, the 10-year Treasury bond yield (the inverse of bond prices) shows a very high correlation to Federal Reserve rate changes. That is because while the Fed controls the short end of the yield curve, the economy controls the long end. Therefore, longer-term yields respond to economic realities as the Fed cuts rates in response to a disinflationary event.

Could this time be different? Sure, but you are betting on a lot of historical evidence to the contrary.

While the hope is that the Fed will start dropping interest rates again, the risk skews toward stocks. As noted, the only reason for Fed rate cuts is to offset the risk of an economic recession or a financially related event. The “flight to safety” will cause a rate decline in such an event. The previous rise in rates equated to a 50% reduction in bond prices. Therefore, a similar rate reversion could increase bond prices by as much as 70% from current yields.

In other words, the most hated asset class of the last two years may perform much better than stocks when the Fed cuts rates.

Therefore, as we approach the first Fed rate cut in September, it may be time to consider reducing equity risk and increasing exposure to Treasury bonds.

The University of Michigan consumer sentiment survey (UM) unexpectedly fell sharply a month ago after steadily improving. The report aligned with recent consumer surveys, retail sales data, and revenues from retail-oriented companies. Last Friday, the latest UM survey further confirmed a downshift in consumers’ sentiment. Let’s start with some perspective on the latest data. The July UM sentiment figure was 66, above the 53.2 set when inflation raged in August 2022. However, it is well below the nearly fifty-year average of 84 and aligns with levels recorded during recessions, as the red dotted line shows in the upper left graph.

Inflation expectations further confirm consumer weakness within the UM survey. As shown in the upper right corner, the expected inflation rate over the next year is back to pre-pandemic levels. The graph on the bottom left shows that house buying conditions are the worst in at least 45 years. Buying conditions for vehicles and durable goods have also retreated significantly. Lastly, the graph on the bottom right shows that expectations for the future are declining in line with current sentiment.

It’s tricky to decipher this analysis. Is the decided decline in consumer sentiment and spending habits based on political preferences and trepidations surrounding the election? Otherwise, it may be that the consumer is running out of gas, having depleted their pandemic-related savings and normalized their spending habits.

What To Watch Today

Earnings

Economy

Market Trading Update

As noted yesterday, the broad market is overbought, and rallies are sold into, limiting the current upside. However, small and mid-cap stocks have been on fire for the last few days, surging higher. It is unsurprising to see narratives popping up as to why these stocks will now take leadership, but many problems still plague these companies.

First, nearly 40% of the Russell 2000 is unprofitable. As we discussed previously:

“However, some issues also plague smaller capitalization companies that remain. The first, as noted by Goldman Sachs, remains a fundamental one.

“I’m surprised how easy it is to find someone who wants to call the top in tech and slide those chips into small cap. Aside from the prosect of short-term pain trades, I don’t get the fundamental argument for sustained outperformance of an index where 1-in-3 companies will be unprofitable this year.”

As shown in the chart by Apollo below, in the 1990s, 15% of companies in the Russell 2000 had negative 12-month trailing EPS. Today, that share is 40%.”

“Besides the obvious fact that retail investors are chasing a rising slate of unprofitable companies that are heavily leveraged and dependent on debt issuance to stay afloat (a.k.a. zombies), these companies are susceptible to actual changes in the underlying economy.”

With a slowing economy, these companies depend highly on the consumer to generate revenues. As consumption decreases, so does their profitability, which will weigh on share performance.

Secondly, these companies do not have the financial capital to execute large-scale buybacks to support asset prices and offset slowing earnings growth by reducing share count.

Lastly, unlike the Mega-caps that dominate the ETF world, small and mid-cap companies do not benefit from the passive flows that continue to support their large-cap brethren. The underperformance of small and mid-caps, relative to large caps, has been a long-term issue.

Technically speaking, the Rusell 2000 index (which comprises both small and mid-cap stocks) is 3 standard deviations overbought. Furthermore, other technical measures suggest the recent move is a bit extreme. Notably, while the recent increase in the Russell 2000 index is encouraging, it should be noted that the index remains well below the previous high in January 2022.

While the Russell 2000 has provided traders with decent opportunities, it is difficult to suggest the recent move is the beginning of a major market shift.

Maybe it will, but there will be plenty of time to make that decision. In the short term, the recent “Trump trade” higher in these stocks has likely run its course, and profit-taking would seem to be a better decision than trying to “jump on that trade” at these levels.

Atlanta Fed Sticky and Flexible Core CPI

Following last week’s CPI data, we thought we might share a unique look at inflation to gain more insight into inflation trends. The graph below compares core CPI to its sticky and flexible components. Sticky prices are those goods that tend to change in price infrequently. Often, economists use sticky inflation to gain confidence in their inflation expectations. Conversely, flexible prices are more volatile. These prices tend to be much more responsive to economic conditions.

The graph below shows that core CPI and sticky prices track each other well. Flexible prices are highly volatile, but they provide helpful information. Often, sharp changes in flexible prices precede changes in sticky prices and CPI. The latest CPI report shows flexible prices are down 1.9% annually. In the last 35 years, they have only been lower twice. The first was at the onset of the pandemic, and the second was almost 20 years ago. While flexible CPI is volatile, it argues that the deflationary trend in core CPI will likely continue.

Market Breadth Improves

The market breadth improved last week. Per the SimpleVisor table below, small-caps, small-and mid-cap value led the way. Mega-cap growth, the best performer over the 20 prior days, was the worst last week, down 1.64% despite the S&P 500 up nearly 1%.

The better breadth can also be seen in the second graphic. Technology and consumer discretionary are not as overbought on a relative basis as they were. Furthermore, the graph on the right shows every sector has a positive absolute score. Additionally, the distance between the highest and lowest has narrowed.

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Coal miners used to bring canaries into the mines to protect themselves from harmful gases. The canary will keel over if the gas levels increase, giving the miners time to exit before meeting the same fate. In the same vein, no pun intended, there is a corporate bond credit spread that can serve as an economic canary.

Corporate credit spreads, or the difference between a bond’s yield and Treasury yields, measure the perceived risk of default. Thus, the higher the spread, the greater the premium investors demand to insure against default. From AAA to junk-rated credit, spreads are historically tight. Thus, investors are not overly concerned about economic weakness, which usually precedes defaults. However, a closer inspection of credit spreads by ratings exposes a bit of a warning.

Our canary is the difference between the highest-rated junk bonds, BB, and the junk bonds closest to default, CCC. As shown, CCC bond spreads have been rising. However, BB spreads continue to drift lower. The increased spread between BB and CCC is only minor. In other words, the canary just coughed. Let’s watch the canary to see if its condition worsens.

What To Watch Today

Earnings

Economy

Market Trading Update

As noted on Friday,

“The rally that began in late October is one of the longest rallies in history. The chart below shows the 37-week rate of change for the S&P 500 index. While there have certainly been periods with larger percentage gains, the current change exceeds 30%, which has historically preceded corrections and consolidations. Conversely, 20% or greater reversions have been decent buying opportunities for investors. The shaded periods show the buying and selling opportunities that have not been that numerous since 1964.”

As discussed last week, the market did indeed flip that “sell signal,” pushing higher and topping 5600 for the first time. However, it also pushed the market back into extremely overbought territory, and the deviation from the 50-DMA is quite significant. Such suggests that, as we saw in late May and June, the market will either consolidate or correct back to the 20-DMA. If the bulls can hold that level again, as they have, the market could continue to push higher. Such is possible given the current exuberance surrounding the Fed cutting rates. However, if the 20-DMA fails, as in early April, the 50-DMA becomes the next logical support, with the 100-DMA close behind. Such would encompass another 3-5% correction.

With the market continuing its “non-stop” advance, the bulls have become emboldened to take on more risk and are unconcerned about the risk of a correction. Such often does not end well, but as Warren Buffett once quipped:

“The markets are a lot like sex; it feels best just before the end.”

The Week Ahead

With inflation and the unemployment reports in the rearview mirror, corporate earnings will take center stage. Leading the list are Goldman Sachs, Bank America, United Healthcare, J&J, Netflix, and American Express. We will be watching to see if companies can maintain higher-than-average profit margins despite normalizing inflation. Furthermore, companies like J&J, American Express, and United will provide insight into personal consumption.

Jerome Powell will speak again today. He may opine on the latest inflation data and how that affects the Fed’s outlook. Also on the calendar is Retail Sales on Tuesday.

Bizarro Stocks

Sentimentrader shared the graph below, showing that fifteen of the last thirty days have seen the S&P 500 index move in the opposite direction as the advance-decline line. The next closest instance, going back to 1928, is 12 days. The table on the top left shows that prior instances when the number of occurrences was above eight were followed by an average annualized return of -7.6%. Furthermore, about 40% of stocks in the S&P 500 are down this year despite the index being up nearly 20%.

Bizzaro stats like these and many others attest to the heavy contribution of large-cap stocks to index returns and how they mask underlying market weakness. The top 30 stocks account for over half of the index. Moreover, Microsoft, Apple, Nvidia, and Amazon account for 25% of the total.

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The Consumer Price Index (CPI) fell 0.1% last month, following 0.0% the prior month and expectations for a 0.1% increase. Core prices rose 0.1%, a tenth below last month’s reading and the consensus forecast. Year-over-year inflation is down to 3.0%.

The better-than-expected inflation data further affirms the disinflation trend may be back on track. The two graphs below, charting the three-month average of the monthly CPI and the year-over-year CPI, show they are nearing the ten-year average preceding the pandemic and well below the high levels we saw in 2022.

Before cutting interest rates, the Fed may want another month or two of CPI and PCE prices at or below the pre-pandemic average. Such would confirm the year-over-year trend is back on a downward trajectory. However, the Fed is now balanced regarding its reaction to prices and the labor market. If the next CPI is low and the labor market shows further signs of cooling, the September FOMC might be when the Fed makes the first rate cut of this cycle. The odds of a cut at the July 31 meeting rose slightly to 10%. Furthermore, the odds are over 80% that they will reduce rates in September.

What To Watch Today

Earnings

Economy

Market Trading Update

As discussed yesterday, the market has continued to rise as investors chase a small handful of stocks. The rally that began in late October is one of the longest rallies in history. The chart below shows the 37-week rate of change for the S&P 500 index. While there have certainly been periods with larger percentage gains, the current change exceeds 30%, which has historically preceded corrections and consolidations. Conversely, 20% or greater reversions have been decent buying opportunities for investors. The shaded periods show the buying and selling opportunities that have not been that numerous since 1964.

Of course, as noted, just because the market rally currently exceeds 30% does not mean a reversal is imminent. It is just a warning that investors should pay attention to as they continue to manage risk.

Greg Valliere’s Washington Insight On Biden’s Chances

As promised, we occasionally provide Greg Valliere’s latest political insights throughout this election season. His 40+ years of experience analyzing and assessing the political landscape helps us gauge what the coming election may bring so we can focus on what that means for our investments.

Beneath his latest thoughts on the coming election and President Biden’s predicament, we share the current betting odds. The source is Election Betting Odds, which aggregates five betting platforms. As of yesterday, Kamala Harris is slightly favored over Joe Biden, while Donald Trump is the clear favorite.

THE ISSUE IS NOT WHETHER JOE BIDEN WILL STEP DOWN — it’s simply when, our sources are reporting, after the president’s campaign essentially collapsed yesterday. We have no idea when Biden will drop out — it could come as early as his press conference today, but more likely not until late July, ahead of the Democrats’ national convention, which runs from Aug.19 until Aug.22.

MOST POLLS SHOW BIDEN TRAILING by only 2 or 3 points nationwide, a remarkably tight margin, considering his disastrous debate performance two weeks ago. Why?

OUR TAKE is that most voters made up their minds months ago — and they tuned out of the cringe-inducing debate. The public shrugged off the Trump guilty verdicts in NYC, which had virtually no impact on the polls.  And the public probably isn’t wondering about Biden’s Parkinson’s doctor.

THE RACE MAY BE SURPRISINGLY CLOSE, but the outlook isn’t good for Biden because he still trails in virtually all of the key battleground states — Georgia, Nevada, Arizona, North Carolina, etc. And in the most important state of all — Pennsylvania — Trump appears to be ahead. Biden has a small lead in Wisconsin and Michigan.

THE ELECTORATE DECIDED MONTHS AGO that Biden was too old to be president, and that concern has grown. The public overwhelmingly believes that Biden isn’t fit to serve for four and a half more years; perhaps the only game changer would be signs that Trump’s cognitive skills are failing — but you underestimate Trump at your own peril.

Is Private Equity For You?

Lance Roberts wrote a thoughtful article this week about private equity. His article, Private Equity – Why Am I so Lucky, helps readers appreciate the rapidly growing $4.4 trillion asset class. Notably, he provides three risks often accompanying private equity investments and why they may be better served for high-net-worth individuals and pension and endowment funds. To wit:

There are significant differences to consider between the vast majority of retail investors and high-net-worth individuals before investing in private equity. The underlying risks of private equity investments can define these differences. There are many risks, but I want to focus on three.

• Liquidity Risk
• Duration
• Loss Absorption

He thoroughly explains those risks and how they differ from traditional investments. Furthermore, he dispels the notion that private equity investments are better than the stocks and bonds most retail investors own. Per the article:

To that point, you should realize that most private equity investments (65%) either fail or return the initial investment at best.

The article does not dissuade individuals from making private equity investments. However, it raises awareness of the risks and complications associated with private equity and how they differ from what most stock and bond investors are used to.

Does this mean that you should never make a private equity investment? Of course not. However, you must understand the risk of investing and the potential ramifications on your financial situation when something goes wrong.

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Some state that “bears are like a ‘broken clock,’ they are right twice a day.” While it may seem true during a rising bull market, the reality is that both “bulls” and “bears” are owned by the “broken clock syndrome.”

The statement exposes the ignorance or bias of those making such a claim. If you invert the logic, such things become more evident.

“If ‘bears’ are right twice a day, then ‘bulls’ must be wrong twice a day.”

In the investing game, the timing of being “wrong” is critical to your long-term goals. As discussed in “The Best Way To Invest,”

“There is a massive difference between AVERAGE and ACTUAL returns on invested capital. Thus, in any given year, the impact of losses destroys the annualized ‘compounding’ effect of money.”

Throughout history, bull market cycles are only one-half of the “full market cycle.” That is because, during every “bull market cycle,” the markets and economy build up excesses that are then “reversed” during the following “bear market.” In other words, as Sir Issac Newton once stated:

“What goes up, must come down.” 

Bulls Are Wrong At The Worst Time

During rising bull markets, the bears become an easy target for ridicule. While the bears have logical arguments for why the markets should reverse, markets can often remain “illogical longer than you can remain solvent,” to quote John M. Keynes. Such is an important point because, as Howard Marks once quipped:

“Being early is the same as being wrong.”

The problem for perennially bearish people is that while they may eventually be deemed correct, they were so early to the call that they became the “boy who cried wolf.”

Robert Kiyosaki, who has long called for a market crash, is a good case study.

“But the real tragedy here is that one day he will be right. One day a crash will come and Kiyosaki will take a victory lap for all to see.

Will his prior incorrect calls matter? Not at all. You can try to point out his flawed track record, but it won’t make a difference. Most people aren’t going to see your reply. But what they will see is his tweet. They will feel the pain from the crash after it happens and then they will think, ‘Kiyosaki knew it all along.’”

Oh he got it wrong eight times before? Who cares? He is right now, isn’t he?” – NIck Mugulli

Nick is correct. No one will remember the “bears” wrong calls when the crash eventually comes. However, Nick is also incorrect because the same applies to the “bulls.”

For example, few remember Jim Cramer’s Top 10 Picks in March 2000 or the bullish media analysts who said “buy” through the entire 2008 crisis? But they remember the eventual “buy” recommendations that were eventually right. Unfortunately, few investors had capital left at that point.

We give Nick a pass because he is young and has not lived through an actual bear market. As anyone who has will tell you, it is not an adventure they care to repeat.

The problem with being “bullish all the time” is that when you are eventually wrong, it comes at the worst possible cost: the destruction of investment capital. However, being “bearish all the time” also has a price, such as failing to grow investment capital to reach financial goals. While some investors left the market to avoid a 50% crash in 2008, they never returned for the subsequent 500% return. What was worse?

While the “bulls” seem to have their way during rising markets, the always-bullish media overlooks a problem. Over the past 120 years, the market has indeed risen. However, 85% of that time was spent making up previous losses, and only 15% making new highs.

The importance of this point should not be overlooked. Most investors’ “time horizon” only covers one market cycle. Suppose you are starting at or near all-time highs. In that case, there is a relatively significant possibility you may wind up spending a significant chunk of your time horizon “getting back to even.”

The “Art Of Being A Contrarian

The biggest problem for investors, and the “broken clock syndrome,” is the emotional biases by being either “bullish” or “bearish.” Effectively, when individuals pick a side, they become oblivious to the risks. One of the most significant factors is “confirmation bias,” where individuals seek confirmation and ignore non-confirming data.

As investors, we should avoid such a view and be neither bullish nor bearish. We should be open to all the data, weigh incoming data accordingly, and assess the risk inherent in our portfolios. That risk assessment should be an open analysis of our current positioning relative to the market environment. Being underweight equities in a rising bull market can be as harmful as being overweight in a bear market.

As a portfolio manager, I invest money in a way that creates short-term returns but reduces the possibility of catastrophic losses that wipe out years of growth.

We believe you should not be “bullish” or “bearish.” While being “right” during the first half of the cycle is essential, it is far more critical not to be “wrong” during the second half.

Howard Marks once stated that being a “contrarian” is tough, lonely, and generally right. To wit:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, particularly when momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

The problem with being a contrarian is determining where you are during a market cycle. The collective wisdom of market participants is generally “right” during the middle of a market advance but “wrong” at market peaks and troughs.

As an individual, you can avoid the “broken clock“ syndrome.

• Avoid the “herd mentality” of paying increasingly higher prices without sound reasoning.
• Do your research and avoid “confirmation bias.” 
• Dev”lop a sound long-term investment strategy that includes “risk management” protocols.
• Diversify your portfolio allocation model to include “safer assets.”
• Control your “greed” and resist the temptation to “get rich quick” in speculative investments.
• Resist getting caught up in “what could have been” or “anchoring” to a past value. Such leads to emotional mistakes. 
• Realize that price inflation does not last forever. The larger the deviation from the mean, the greater the eventual reversion. Invest accordingly. 

Being a contrarian does not mean always going against the grain regardless of market dynamics. However, it does mean that when “everyone agrees,” it is often better to look at what “the crowd” may be overlooking.

The Fed’s balance sheet peaked at $9 billion in April 2022. Today, after two years of Quantitative Tightening (QT), it has fallen to $7.2 trillion. When the Fed embarked on QT, its goal was to “normalize” its balance sheet. At the time, the St. Louis Fed claimed the purpose of QT was:

“This policy, termed balance sheet “normalization” or “quantitative tightening” (QT), is designed to drain excess liquidity from the banking system. QT is the opposite of quantitative easing (QE).”

Today, after a healthy dose of QT, the Fed’s balance sheet is still far from normalized. It is over $5 trillion larger than in 2008 when Ben Bernanke promised that the initial round of QE was a temporary measure to stabilize the economy and markets.

Might today’s and many continued rounds of QT normalize the Fed’s balance sheet? We doubt it, and so does the Fed. In our latest article, Fiscal Dominance Is Here, we discuss the bind the Fed is in and how they must enact monetary policy with the massive Federal debt load in mind. Powell will never admit that monetary policy is beholden to the nation’s debt. However, the Fed does. The graphs below from the Fed project its SOMA account, which holds their bonds, will grow by 8-10% a year starting in 2025. The Fed and Treasury have no choice if deficits continue!

What To Watch Today

Earnings

Economy

Market Trading Update

The market is poised to move higher again today if the CPI report confirms what the market is expecting – cooler inflation. With Jerome Powell heading into the FOMC meeting at the end of the month, the recent spat of weaker data has hopes mounting that the Fed could cut rates in July. That hope was recently underpinned by comments from Powell that he doesn’t want to wait too long to cut rates and risk undermining economic growth. That risk is clearly reflected in consumer interest payments (non-mortgage) as a percentage of disposable income, which has risen sharply. The longer high borrowing costs remain, the risk of a recessionary draw down increases.

Do not dismiss that risk. When it comes to the financial market, investors are chasing a handful of stocks higher based on expectations of exponential earnings growth in the future. However, a recessionary onset will undermine those expectations as earnings fall and valuations reset. As shown, the last time that the largest 7-stocks outperformed the rest of the market to such a degree was heading into the “Dot.com” bubble. While this time is indeed different, it is unlikely that it is different enough to create infinite earnings growth.

While we remain long equities in our portfolio currently, as we will discuss in this weekend’s newsletter, we are starting to aggressively research multiple hedging strategies to reduce portfolio risk heading into the end of summer. Such a move certainly seems prudent.

Forward Earnings Projections Appear Optimistic

Corporate earnings tend to be well correlated with economic activity. Also, as the graph below from Yardeni Research shows, forward earnings correlate well with current economic growth. Keep in mind that forward earnings are forecasts, not actual earnings. Recently, as Yardeni highlights with the yellow arrows, forward earnings expectations have been rising while the GDP growth rate has been declining. Therefore we must ask, can earnings expectations continue increasing if the economy slows beyond the natural growth rate? We doubt it, but never rule anything out in this market.

More On Construction Employment

Yesterday’s Commentary touched on the significant jump in construction worker layoffs in the latest Challenger report. We track the sector closely because construction jobs have played a significant role in the robust job market. And as you know, the strong labor market is one reason the Fed is apprehensive about cutting interest rates.

The graph below, courtesy of CoStar, warns that the Challenger warning may not be a one-month anomaly. As measured in square footage, the amount of new commercial projects getting underway has plummeted from over 200 million square feet to just over 50 million. Such is the lowest since the aftermath of the financial crisis.

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Fed Chair Jerome Powell testified to Congress yesterday and updated them with the Fed’s latest views on the economy, inflation, and monetary policy. The Fed has kept rates at current levels in part because the labor market was tight. Chair Powell’s concern was that higher wages due to a shortage of workers would feed inflation. In his testimony, Chair Powell claimed that is no longer a concern. To wit:

The most recent labor market data sent a pretty clear signal that the labor market has cooled considerably and appears to be fully back in balance.

Regarding monetary policy, he said, “It’s not likely the next move will be a rate hike.” Further, he continued to stress the risks the Fed faces. Per his speech:

In light of the progress made both in lowering inflation and in cooling the labor market over the past two years, elevated inflation is not the only risk we face. Reducing policy restraint too late or too little could unduly weaken economic activity and employment.

On the inflation front, Chair Powell appears to be getting more optimistic that the recent inflation readings are heading lower again. “More good data would strengthen our confidence that inflation is moving sustainably toward 2%.”

He did not break new ground, but his general tone indicates the Fed wants to cut rates. However, they want more data confirming that the inflationary tailwinds are fading quickly. As shown below, the market favors a rate cut in September. The odds of a cut in July remain low at 5%.

Construction Job Layoffs Rising

The graph below, courtesy of Longview Economics, shows an unusual jump in the number of layoffs in the construction industry. Similarly, the recent data on building permits and housing starts have been slowing rapidly. Accordingly, layoffs in the industry should not be shocking.

There are approximately 8 million construction workers in the labor force. The sector has been one of the leading growth sectors over the last few years. Therefore, we should watch whether the layoffs continue in the Challenger data and if they also appear in the BLS data.

As Longview states:

Unusual to get such a large monthly ‘construction’ layoffs data point Way too soon to extrapolate. BUT a second similar month at this level would be troubling (especially when many other labour market indicators are so soft!)

Tobin’s Q Ratio At A Record High

The graph below, courtesy of ASR Ltd., shows that the Tobin Q ratio is now at its highest level in nearly 125 years. Tobin’s Q ratio uses the market value and replacement value of a company’s assets to determine if they are over or undervalued. When the ratio is greater than one, it means the market values the company more than the value of its assets. Therefore, today’s record readings imply expectations for high growth and, ultimately, profits.

Like Tobin’s, many valuation metrics are at or near historic highs. However, technically, the market remains very strong. Accordingly, investors need to pay close attention to technical warnings that could result in some normalization of valuations.

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As quoted below from an executive summary of a joint report by the Department of Treasury and the Office of Management and Budget (OMB), the current deficit policy is deemed unsustainable. However, they fail to mention how long the Fed, via fiscal dominance, can sustain the unsustainable.

“The debt-to-GDP ratio was approximately 97 percent at the end of FY 2023. Under current policy and based on this report’s assumptions, it is projected to reach 531 percent by 2098. The projected continuous rise of the debt-to-GDP ratio indicates that current policy is unsustainable.” – Financial Report of the United States Government  -February 2024.

Fed speakers will deny any notion that its monetary policy aims in part to help the government fund her debts. Regardless of what they say, we are already in an age of fiscal dominance. Monetary policy must consider the nation’s debt situation.  

Fiscal Dominance

Fiscal dominance is a condition whereby the amount of debt in an economy reaches a point where monetary policy actions must allow Federal debts and deficits to be serviced and funded cost-effectively. By default, such monetary policy decisions will often come at the expense of traditional employment and price goals. As a result, the Fed must further distort the price of money and ultimately lessen the wealth of the nation’s citizens.

The age of fiscal dominance is here. Consider the following paragraphs and graph from our article Stimulus Today Costs Dearly Tomorrow.

A lender or investor should never accept a yield below the inflation rate. If they do, the loan or investment will reduce their purchasing power.

Regardless of what should happen in an economics classroom, the Fed has forced a negative real rate regime upon lenders and investors for the better part of the last 20+ years. The graph below shows the real Fed Funds rate (black). This is Fed Funds less CPI. The gray area shows the percentage of time over running five-year periods that real Fed Funds were negative. Negative real Fed Funds have become the rule, not the exception.

Soaring Debt Outstanding and Rising Rates

The government has added $2.5 trillion in debt over the last four quarters. Of that, over $1 trillion was to pay its interest expenses on the entire debt stock. Despite recent high interest rates, the average interest rate on the debt is still relatively low at 3.06%.

The two graphs below show why a relatively minimal uptick in the average interest rate on the debt is so troublesome. The federal debt (blue) has grown by 8.5% annually over the last ten years. Despite the amount of debt more than doubling over the period, the interest expense on the debt until very recently has remained very low. The first graph shows that the average interest rate increase is barely visible. However, the second graph shows that the rise in the government’s interest expenses is substantial.

As debt issued years ago with low interest rates matures and new debt with higher interest rates replaces it, the interest expense will keep rising. For context, if we assume the government’s average interest rate is 4.75%, likely close to their weighted average rate on recent debt issuance, the interest expense will rise to $1.65 trillion, not including new debt.

$1.65 trillion is over $300 billion above the government’s next largest expenditure, Social Security. Furthermore, it is double defense spending for 2023. The annual federal deficit has only been above $1.65 trillion twice (2020 and 2021) since its founding in 1776.

While the situation may sound gloomy, lower interest rates solve the problem. If interest rates return to the levels existing before 2022, the interest expense could easily fall below $700 billion, about half of the cost than if rates remain at current levels.

Therefore, interest rates will have to be kept in check by the Fed.

The Fed Understands Their Role

In 2008, Ben Bernanke said QE was a temporary measure that would be reversed once the economy and markets returned to normal. Trillions worth of Treasury purchases later, and the Fed now tells us it’s permanent. Consider the following graph and paragraph by the New York Fed.

“Under the two purely illustrative scenarios, the size of the SOMA portfolio continues to decline to $6.5 trillion and $6.0 trillion, respectively. The portfolio size then remains steady for roughly one year before increasing to keep pace with growth of demand for Federal Reserve liabilities, reaching $9.2 trillion and $8.4 trillion, respectively, by the end of the forecast horizon in 2033.”

The SOMA portfolio is the Fed’s System Open Market Account Holdings. This is the portfolio that holds bonds purchased via QE as well as its other monetary operations.

The graph on the left shows that the Fed expects the SOMA account to rise by about 40% starting in later 2024 through 2032. More importantly, the graph on the right shows that its increase will be commensurate with GDP. In other words, the Fed will continue to help fund the deficit by buying Treasury debt.

Monetary Policy

We know how QE and lower interest rates cut interest expenses, allowing the government to spend recklessly. However, there are other ways the Fed can supplement their efforts if needed. For instance, in our daily Market Commentary from April 24^th, we shared the following:

If enacted, the new bank rules would force all banks to “preposition billions more in collateral” at the Fed to support future discount window borrowing. The article estimates that the Fed would require collateral matching up to 40% of a bank’s uninsured deposits, accounting for about 45% of the $17.5 trillion commercial bank deposits. Further, the new rules would require the banks to borrow from the window numerous times a year to help remove the program’s stigma.

In addition to bolstering the banking safety net, it would also force banks to hold significant collateral balances at the Fed. Collateral for Fed loans is quite often U.S. Treasury securities. Accordingly, this new bank rule is another way to help the Treasury fund its massive deficits and stock of outstanding debt from years past.

In late March, we shared another idea floating around Wall Street. Per our article QE By A Different Name Is Still QE we wrote:

Rumor has it that the regulators could eliminate leverage requirements for the GSIBs. Doing so would infinitely expand their capacity to own Treasury securities. That may sound like a perfect solution, but there are two problems: the banks must be able to fund the Treasury assets and avoid losing money on them.  

The bank bailout BTFP enacted in March 2023 addresses the problems. As we wrote:

In a new scheme, bank regulators could eliminate the need for GSIBs to hold capital against Treasury securities while the Fed reenacts some version of BTFP. Under such a regime, the banks could buy Treasury notes and fund them via the BTFP. If the borrowing rate is less than the bond yield, they make money and, therefore, should be very willing to participate, as there is potentially no downside.

Summary

With the Fed willingly helping the government fund her debts, we believe the odds are small that any significant deficit reduction is possible. While the path is unsustainable, it is likely much longer than most pundits appreciate.

However, fiscal dominance comes with a significant cost. The Fed fuels the widening wealth gap by manipulating interest rates and indirectly influencing the stock market. As we have seen glimpses over the last five years, social unrest will likely become more prevalent. With that comes poor economic confidence from consumers and businesses, which in turn generates a headwind to the economy.

It’s not too late to try and fix our fiscal problems, but time is ticking. As the saying goes, Rule #1 of holes: when you are in one, the first thing to do is stop digging.

A reader asked us how concerned we are about the market’s extension from crucial moving averages. The short answer is we are. But that doesn’t mean we are moving our equity holdings to cash. We continue to hold our equity positions for two reasons but we remain vigilant.

First, the S&P 500 is doing great, but only because of a small handful of the largest-cap stocks. This imbalance is getting extreme. However, the condition doesn’t require a sharp downturn to correct itself. Simply, the other 480 or so stocks that have been underperforming can outperform without the market declining.

Secondly, similar historical deviations from important moving averages offer no conclusive evidence of an imminent downturn. The graph on the left shows the S&P 500 and its 200dma. The green line is the percentage market deviation from the 200dma. As the dotted line shows, the current instance is somewhat extreme but can remain so for a while. The scatter plot on the right compares the standard deviation of the market divergence from the 200 DMA with forward 100-day returns. The yellow bar is where the market currently is. Again, based on prior instances, an impending downturn is not a foregone conclusion. Furthermore, the R2 shows there is no correlation between the two factors.

The bottom line: watch for technical signs the market is breaking down but appreciate this current condition can continue.

What To Watch Today

Earnings

Economy

Market Trading Update

FOMC Minutes

Last Wednesday, after the market closed early for the July 4th holiday, the Fed released its minutes from the mid-June meeting. The minutes were generally dovish. In particular, the Fed seems to be getting more comfortable with continued disinflation. Per the minutes:

“Participants highlighted a variety of factors that were likely to help contribute to continued disinflation in the period ahead. The factors included continued easing of demand–supply pressures in product and labor markets, lagged effects on wages and prices of past monetary policy tightening, the delayed response of measured shelter prices to rental market developments, or the prospect of additional supply-side improvements. The latter prospect included the possibility of a boost to productivity associated with businesses’ deployment of artificial intelligence–related technology.”

Nevertheless, participants suggested that a number of developments in the product and labor markets supported their judgment that price pressures were diminishing. In particular, a few participants emphasized that nominal wage growth, though still above rates consistent with price stability, had declined, notably in labor-intensive sectors. A few participants also noted reports that various retailers had cut prices and offered discounts. Participants further indicated that business contacts reported that their pricing power had declined. Participants suggested that evidence of firms’ reduced pricing power reflected increased customer resistance to price increases, slower growth in economic activity, and a reassessment by businesses of prospective economic conditions.

Their disinflationary views are supported by their opinions on the labor market, which they believe has primarily normalized.

Several participants also suggested that the establishment survey may have overstated actual job gains. Several participants remarked that a variety of indicators, including wage gains for job switchers, suggested that nominal wage growth was slowing, consistent with easing labor market pressures. A number of participants noted that, although the labor market remained strong, the ratio of vacancies to unemployment had returned to pre-pandemic levels and there was some risk that further cooling in labor market conditions could be associated with an increased pace of layoffs. Some participants observed that, with the risks to the Committee’s dual-mandate goals having now come into better balance, labor market conditions would need careful monitoring.

Tesla Powers Consumer Discretionary Stocks

Last week, Tesla was up over 25%, leading the market higher and contributing to the gross outperformance of the consumer discretionary sector (XLY). Tesla accounts for roughly 2% of the S&P 500. Thus, last week’s gain contributed to over a third of the market’s 1.4% increase. Tesla also contributes about 30% to XLY. XLY was up about 3% last week. Tesla added over 6%; therefore, the sector would have been down by approximately 3% without Tesla.

Tesla and Amazon are overbought compared to the market, while most consumer discretionary stocks are grossly oversold (bright green). The first graphic below, courtesy of SimpleVisor, shows that most discretionary stocks are grossly oversold. This is another example of the extreme performance bifurcation we are witnessing. The five-day heat map also shows the massive performance divergence. Note how many of the largest stocks by market cap had great five-day performances. However, the large majority of stocks were lower on the week.

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Lately, I have been getting many questions about investing in private equity. Such is common during raging bull markets, as individuals seek higher rates of return than the market generates. Also, during these periods, Wall Street tends to bring new companies to market to fill the demand of the investing public. Private equity is always alluring, as is the tale of someone who bought the company’s shares when it was private and made a massive fortune when it went public.

Who wouldn’t want a piece of that?

The private equity (PE) business is huge. When I say huge, I mean $4.4 Trillion huge.

Those PE companies have been extremely busy over the last several years. While there has been a surge in private equity startups, there has also been the privatizing of public companies. The Atlantic shared some data about the dwindling number of publicly traded stocks along with the corresponding growth in private equity investments:

The publicly traded company is disappearing. In 1996, about 8,000 firms were listed in the U.S. stock market. Since then, the national economy has grown by nearly $20 trillion. The population has increased by 70 million people. And yet, today, the number of American public companies stands at fewer than 4,000. How can that be?

One answer is that the private-equity industry is devouring them.

In 2000, private-equity firms managed about 4 percent of total U.S. corporate equity. By 2021, that number was closer to 20 percent. In other words, private equity has been growing nearly five times faster than the U.S. economy as a whole.

PE firms managed less than $1 billion in the mid-1970s. Today, it’s more than $4 trillion. There is more than $2.5 trillion in dry powder alone globally:

However, that “dry powder” is problematic for PE companies as they must invest it or return it to the investors. Therefore, the demand for deals often means that the deals getting funding may not be the “best” deals.

That is a substantial risk we will discuss in more detail momentarily.

Is Private Equity Right For You?

Many individuals hear tales of how high-net-worth individuals (the smart money) own private equity in their allocations. As shown in the chart below from Long Angle, roughly 17% of their allocations are to private equities. These reports don’t generally tell you that their allocation to “private equity” often tends to be their personal businesses. Nonetheless, individual investors frequently see this type of analysis and think they should be replicating that process. But should they?

There are significant differences to consider between the vast majority of retail investors and high-net-worth individuals before investing in private equity. The underlying risks of private equity investments can define these differences. There are many risks, but I want to focus on three.

1. Liquidity Risk
2. Duration
3. Loss Absorption

Liquidity Risk: Many individuals don’t realize when entering into private equity investments that they cannot liquidate them if capital is needed for another reason. While investors often enter into private equity with the anticipation of making outsized returns, they frequently leave themselves vulnerable to the impact of having capital tied up in an illiquid investment. When the eventual crisis happens, the illiquid status of private equity becomes problematic.

Duration Risk: The duration of private equity can often be much longer duration than initially estimated. When a private equity deal is pitched to an individual, it is always accompanied by the most optimistic projections. The projections always include optimistic exit assumptions where the individual will receive an enormous windfall. More often than not, the projections fall very short of reality. A market downturn, economic recession, or a change in underlying industries, interest rates, or inflation can turn an initial 3-year investment into a decade or more. That duration risk multiplies the liquidity risk of keeping capital tied up for much longer than anticipated, sometimes with little or no return. While high-net-worth individuals can absorb both the duration and liquidity issues, most individual investors can not.

Loss Risk: Lastly, high-net-worth individuals can absorb losses. Many private equity deals inevitably fail, leaving investors with enormous losses on their balance sheets. While high-net-worth investors can invest in numerous deals, the hope is that a successful private equity venture will offset the losses of one or more that failed. Individuals often do not have the capital for that kind of diversification, and a loss on a private equity investment can be very detrimental. The chart below from S&P Global shows the number of private transactions terminated between 2020-2023.

To that point, you should realize that most private equity investments (65%) either fail or return the initial investment at best.

Yes, private equity can be very lucrative. Depending on the deal you invest in, it can also be very harmful. This brings us to the most important question to ask: “Why am I so lucky?”

Why Am I So Lucky?

If you are approached by someone pitching a “private investment,” the first question you should ask is, “Why am I so lucky to be given this opportunity?”

As noted above, the global PE dry powder has soared to an unprecedented $2.59 trillion in 2023 as a slow year in dealmaking closes with limited opportunities for firms to deploy capital raised in previous years. The dry powder total as of Dec. 1st represented close to an 8% increase over December 2022, according to S&P Global Market Intelligence and Preqin data.

That capital is held by some of the largest PE companies in the world. The list below is just a view of the names that you will likely recognize.

Importantly, as noted, these firms must deploy that “dry powder,” or they will eventually lose it. As such, they have armies of employees to scout for the best opportunities, analysts, legal and accounting professionals to analyze those deals, and immediate capital to fund them.

Therefore, as an individual, several questions need to be thoroughly answered.

If this private equity investment is such a good opportunity, then:

1. Why did the company not approach one of the major P/E firms with capital ready to invest?
2. If they did and were turned down, why?
3. How many private equity investors did the company approach before you contacted me?
4. What is the track record of this salesman’s previous investments in private equity, if any?
5. Can you analyze the many investment risks associated with illiquid investments?

Yes, some private equity transactions are too small for a major private equity company like Black Rock, which must invest billions at once. However, many mid-tier private equity companies will take those types of deals.

Most importantly, for you to “exit” the investment and realize the windfall, does the person selling you the investment have the network of investment banks, market makers, and institutions to provide that exit? Finding a future buyer or taking a company from private to public can be exceedingly difficult without that network.

These are just some things to consider before committing your hard-earned capital to a risky, highly illiquid investment.

Does this mean that you should never make a private equity investment? Of course not. However, you must understand the risk of investing and the potential ramifications on your financial situation when something goes wrong.

So, “Why am I so lucky?”

A year ago, the Fed Funds futures market thought the Fed would have cut rates two to three times before the July 31, 2024 FOMC meeting. Two weeks ago, the odds of a rate cut at the July 31 meeting were near zero. Furthermore, the market was only pricing in one cut for the remainder of the year. With Friday’s jobs report, a fragile ISM report detailed below, and renewed signs that the disinflation trend may be resuming, the prospect of a July 31 rate cut back into focus.

On Friday, the BLS reported the economy gained 206k jobs. The growth was slightly better than expected; however, the unemployment rate rose from 4.0% to 4.1%. Further, the April and May jobs figures were revised lower by 111k in aggregate. Like the prior few employment reports, this report was good from a headline perspective, but a look beneath the hood is troubling.

So, with the unemployment rate ticking up, might the Fed cut rates as soon as July if this week’s inflation data is weak? While the odds remain low, we will watch Jerome Powell’s speeches on Tuesday and Wednesday for clues. This weekend’s Newsletter discusses why the thought of a Fed cut in July is not unthinkable. Per the article, “We don’t think so, but the data is becoming more supportive of action. However, if the Fed cuts rates in July, it is likely a good signal that we will need to become less aggressive on equity allocations.“

What To Watch Today

Earnings

• There are no significant reports today.

Economy

• There are no significant reports today.

Market Trading Update

The market continues in a very bullish trend, with investors increasingly confident that they will receive higher returns. That infectious greed has also spilled over onto professionals, with their equity exposure exceeding 100%. While such is a warning sign, it does not necessarily mean the markets will have a deep correction. However, such positioning extremes have previously marked short-term tops and consolidations.

Furthermore, the market’s deviation from the underlying 200-DMA is also starting to reach levels that have previously preceded short-term market corrections or consolidations. As is always the case, for an “average” to exist, the market must trade above and below that average over time. Therefore, the more extreme the deviation from that average, the stronger the pull for a reversion.

These are warning signs that the market needs a short-term correction or consolidation to alleviate those conditions. Such a process would be healthy for a continued bullish advance. However, it doesn’t mean it will happen today or this month. As is always the case, timing is the critical part.

Trade accordingly.

The Week Ahead

This week will be highlighted by CPI on Thursday, PPI on Friday, two Jerome Powell appearances, and the start of earnings reporting season.

If the Fed is going to cut rates on July 31, it will likely require a lower-than-expected CPI number. The market expects CPI to rise by 0.1% and Core CPI by 0.2%. After declining by 0.2% last month, PPI is expected to increase by 0.2%. Jerome Powell speaks on Tuesday and Wednesday. He will likely have the inflation reports before the speeches.

Earnings season kicks off this week, with the large banks reporting earnings on Friday. The following week, a broader array of company earnings reports will be released.

ISM Services Was Much Weaker Than Expected

For the first time since 2009, excluding April and May of 2020, the ISM services index (blue- -lower graph) is in economic contraction territory. Wednesday’s reading of 48.8 was well below estimates of 52.7 and the prior reading of 53.8. Within the index, the prices paid index was weaker than expectations although still above 50, pointing to higher prices. That said, the manufacturing and services ISM are seeing their price indexes resume lower trends. Of the most concern is the employment index. It came in at 46.1, well below the estimate of 49.5. Such further affirms that the BLS headline job growth figures may be overstating the actual state of the labor markets. This is not lost on the Fed as they have acknowledged such.

New orders, a good leading indicator of activity, were also well below expectations at 47.3 versus an expected 53.6. The first graph below shows a robust leading economic indicator for the service sector. The ratio of order backlogs to inventory sentiment is in recessionary territory. Furthermore, within the report is the following quote:

The percentage of ISM Services respondents expecting higher new orders is at its lowest since the GFC and lower than ’01 recession

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As we shared on Monday, The Fed Funds Rate Is Too High. The biggest reason is the Fed fears another round of inflation. Therefore, they try to ensure it doesn’t happen via tight money policy. Second, federal deficits have been larger than average, causing a jump in Treasury debt issuance. This is primarily the function of an extra $500 billion a year in interest expenses due to higher interest rates. However, significant deficit spending certainly does not help the cause. Lastly, there is R Star, an explanation many may not have heard of.

R Star is the real neutral rate of interest that balances the economy. Unfortunately, there is no way to calculate an economy’s R Star. Hence, managing interest rates to the figure is a guessing game for the Fed. Some economists and bond investors believe the R Star has increased over the past four years due to the pandemic. Therefore, bond yields should be higher if the natural economic growth rate is higher.

On Wednesday, New York Fed President Williams debunks the idea of a higher R Star. He states:

“Although the value of R Star is always highly uncertain, the case for a sizable increase in R-Star has yet to meet two important tests.”

The first is the “interconnectedness” of R Star across countries. There is no evidence that it is rising in Europe or other developed nations. Actually, it is likely declining in Europe, the UK, and China. “Second, any increase in R Star must overcome the forces that have been pushing R Star down for decades.” Have productivity and demographic trends suddenly changed for the better? Again, there is no evidence this is occurring. The two Fed economic models below show that R Star remains on the same trend for the last 40 years.

What To Watch Today

Earnings

• No notable earnings reports

Economy

Market Trading Update

Last week, we noted that we were about to enter Q2 earnings season.

“Speaking of earnings, analysts have been extremely busy over the last 30 days, slashing estimates. In June, Q2 earnings estimates for the S&P 500 index were cut by $5/share to the lowest level yet. Interestingly, while Wall Street continues to boast confidence in rising asset prices, they have cut estimates from $214/share in March last year to just $193/share. Such suggests a dichotomy between expected market performance and the economy, which is where earnings come from.”

For a deeper discussion on Q2 earnings, read “Earnings Bar Lowered.”

As noted, I am using Wednesday’s closing data for the current analysis before I head out for vacation. First, while markets hit an all-time high, I wouldn’t read much into it. Trading volume was light due to the shortening of the week for the Independence Day holiday week. Secondly, while the market did make a new high, it remains a marginal new high tracking along the 20-DMA, which continues to act as bullish support.

The market remains overbought short-term, but the recent rally is close to flipping the short-term MACD “sell signal.” Such would suggest that while the overbought condition could limit the upside, the market will likely try to climb higher over the next two weeks. Continue to manage portfolio risk accordingly, but the bullish trend remains intact.

As noted, investors remain very optimistic about the market currently. Net bullish sentiment remains elevated, volatility is suppressed, and “bad news remains good news” for now.

Did Stocks Peak In June?

No, at least according to the last 75 years of history. The graph below, courtesy of Ryan Detrick of Carson, shows that the S&P 500 has never peaked for the year in June. However, not surprisingly, the odds of an annual high steadily increase from here.

ADP Job Growth

ADP job growth, calculated from actual employment data and not surveys like the BLS, shows that the economy added 150k jobs last month. This is the lowest monthly growth since January. For context, ADP job growth averaged +178k from 2012 through 2019. Over the last twelve months, it has averaged 194k. The current reading (150k) is below both long-term and short-term trends but not overly concerning. That is not to say that the lower trend won’t continue, thus raising concerns in the future.

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Recently, a few media outlets have warned of the imminent demise of the petrodollar agreement, commonly called the petrodollar. With such narratives comes investor anxiety. Consider the following article titles on the topic.

• OPEC Will Sever Link With Dollar For Pricing Oil- The New York Times
• The Petrodollar Is Dead and that’s a big deal- FX Street
• After 50 Years, Death of the Petrodollar Signal End of U.S. Hegemony- The Street Pro

Before jumping to conclusions, let’s discuss what the petrodollar is and isn’t. With that knowledge, we can address concerns about the death of the petrodollar. Furthermore, we can discredit menacing headlines like- Petrodollar Deal Expires; Why This Could Trigger ‘Collapse of Everything.’

Before starting, we need to make a disclaimer. The New York Times article we bullet point above is not recent. We added it to show this is not a new story. The article dated June 1975 starts as follows:

LIBREVILLE, Gabon, June 9 — The oil‐producing nations agreed today to sever the link between oil prices and the dollar and to start quoting prices in Special Drawing Rights, the governor of the Iranian national bank, Mohammed Yeganeh, said.

What Is The Petrodollar?

In 1974, following the economically devastating oil embargo in which the price of crude oil per barrel rose four-fold, sparking a surge in inflation and weakening the economy, the U.S. desperately sought to avoid another embargo at all costs. U.S. politicians theorized that a stronger relationship with Saudi Arabia would go a long way toward achieving its goal.

Fortunately, the Saudis also hoped for a beneficial relationship with the U.S., and they needed a trustworthy investment home for their new oil riches. They also desired better military equipment. At the time, Saudi Arabia was running a huge budget surplus because of its windfall from high oil prices and relatively minor spending needs from within the country.  

While there was never a formal petrodollar pact, it is widely believed that the U.S. and Saudi Arabia had a handshake agreement to meet each other’s needs. Saudi Arabia was encouraged to invest its surplus dollars in safe, high-yielding U.S. Treasury securities. In exchange, the U.S. would sell Saudi Arabia military equipment. Both hoped a better relationship would be a productive byproduct. Such is the petrodollar agreement.

The Petrodollar Was Not Really About The Dollar

We think the petrodollar discussions were principally about Saudi Arabia needing a safe home for their surpluses and the U.S. seeking dollars to fund her large fiscal deficits. While the dollar would be the currency for said transactions, it was not likely the focus of the talks.

In dealing with the immense costs of the Vietnam War and ambitious social spending to pacify social unrest, America sought deficit funding. Saudi Arabia needed to invest its surpluses. Given the unprecedented liquidity and safety of the U.S. Treasury market compared to other options, the “agreement” made a lot of sense for both parties. Furthermore, because Saudi oil revenue would be used to buy dollar-based U.S. Treasury bonds, it made sense for Saudi Arabia to require other oil buyers to pay in U.S. dollars.

We share two graphs to better appreciate the deteriorating U.S. fiscal position at the time. The first graph below highlights the deficits during the mid-1970s. Today, many would consider a $50—or $60 billion deficit minimal. But then, the deficits incurred were a sharp departure from the norm.

The second graph provides proper context. The nation was experiencing more significant federal deficits in the mid- to late 1970s than it faced during World War II. Given the immense spending on World War II, that fact was stunning to many people at the time.

Saudi Arabia Doesn’t Have Investible Dollars

Today, the situation is different. America still desperately needs funding, but Saudi Arabia doesn’t have budget surpluses to invest. Per a Bloomberg article entitled The Petrodollar Is Dead, Long Live The Petrodollar:

Fast forward to today, and Saudi Arabia doesn’t have a surplus to recycle at all. Instead, the country is borrowing heavily in the sovereign debt market and selling assets, including chunks of its national oil company, to finance its grand economic plans. True, Riyadh still holds significant hard currency reserves, some of them invested in US Treasuries. But it’s not accumulating them anymore. China and Japan have significant more money tied up on the American debt market than the Saudis do.

The Reserves Monopoly

Many believe the U.S. government bullies foreign countries into using the dollar, thus forcing them to have dollar reserves. Such seems logical as the reserves must be invested and can help fund our deficits.

We do not know what our politicians say to other countries behind closed doors. But we presume some “persuasion” presses other countries to use the dollar. Regardless, there are not many options for the dollar.

The U.S. offers other nations the best place to invest for four primary reasons. As we outline in Four Reasons The Dollar Is Here To Stay:

The four reasons, the rule of law, liquid financial markets, and economic and military might, all but guarantee the death of the dollar will not occur anytime soon. 

No other country has all four of those traits. China and Russia lack the rule of law and liquid financial markets. Russia also has a small and fragile economy. Europe does not have liquid enough capital markets or military might.

Gold and Bitcoin are often rumored candidates to usurp the dollar. For starters, they do not earn a return on investment. Possibly more problematic, their prices are incredibly volatile. There are many other difficulties precluding them from full-fledged currency status, which we will save for another article.

Summary

Notwithstanding whether there was a formal agreement, the petrodollar is not going anywhere. Even if Saudi Arabia accepts rubles, yuan, pesos, or gold for its oil, it will need to convert those currencies into dollars in almost all instances.

Consider that Saudi Arabia keeps its currency value pegged to the dollar, as shown in the graph below, courtesy of Trading Economics. They also hold approximately $135 billion of U.S. Treasury securities, a three-year high. Does it seem like Saudi Arabia is trying to disassociate from the U.S. dollar and U.S. financial markets?

Stories like those on the petrodollar and others on the “imminent” death of the dollar have been around for decades. Someday they will be right, and the dollar will follow the way of prior global reserve currencies. But for that to happen there needs to be a better alternative, and today, nothing even close exists. 

Tuesday’s JOLTs report is one of many data points showing that the labor market is near or back to the prevailing conditions before the pandemic. It’s not just JOLTs and the labor market normalizing; most other economic indicators show the economy is finally normalizing at pre-pandemic levels.

Yesterday’s Commentary argued that while the unemployment and PCE inflation rates are not far from the Fed’s longer-term projections, the Fed Funds rate is too high, at almost 3% above their extended forecast. Given that divergence, we wrote: “Even if the economy continues to chug along without a recession, it appears that barring higher inflation, significant rate cuts in the coming year will be consistent with the Fed’s economic outlook.”

A reader asked us: “If the economy is normalizing, what comes next?” The oft-used airplane analogy may be the best way to answer. Can the Fed bring the economy back to a typical economic cruising altitude and keep it there? Or might the downward trajectory continue, leading to a soft or hard landing? Given that most other major economies exhibit little economic growth and the Fed is applying tight monetary policy, a new period of higher-than-average growth is the least likely scenario. However, that could change if significant fiscal stimulus follows the election. We are looking for signs that the economy might continue to weaken, thus prompting recession calls. However, the Wall Street consensus is for smooth sailing ahead. Stay tuned!

What To Watch Today

Earnings

Economy

Market Trading Update

In yesterday’s commentary, we discussed the drastic drop in bond ETFs, which sparked many questions. As usual, most things don’t mean anything. Intra-day and daily price movements in anything are usually unrelated to any macro theme and are a function of short-term overbought or oversold conditions.

Such is the case with the market as we begin the year’s second half. Historically, performance tends to be stronger in the first half of the month and weaker in the last half. August and September also tend to be weaker, particularly in election years.

Interestingly, we are now repeating much of what we said this time last year. In 2023, the markets were racing higher, hoping for Fed rate cuts and the “artificial intelligence” craze. At that time, markets were overbought and deviated from their means, but momentum was very strong as volatility remained suppressed. Then, like today, we were warning of the potential for a 5-10% correction to reverse some of those conditions.

As shown, the beginning of this year has been almost a mirror image of last year, with market performance very close. Will the correlation continue, and we see a correction this summer, or will this time be different? I don’t know for certain, but the similarity is eerie, and the risk of correction is elevated in the near term. Trade accordingly.

More On Bad Breadth

The graph below from Ned Davis Research is very telling for two reasons. First, thus far in 2024, the percentage of stocks outperforming the S&P 500 is at a record low, going back about fifty years. This follows a near-record low in 2023. Looking back, there is only one other instance of two consecutive years with such poor market breadth: 1998 and 1999.

While comparing the internet era in the late 1990s to the AI era today may seem appropriate, it’s important to remember the old adage: “Markets can remain irrational longer than you can remain solvent.” The point is that while the market will correct at some point, and yes, AI and other stocks with massive price surges can fall by 30, 40, or even 50% or more, that may not occur for a while.

Accordingly, appreciate the risks and realize a correction is highly likely. However, to better anticipate such an event, close attention must be paid to the market technicals. As they always have, they will alert us when to take a more conservative posture.

Jerome Powell’s Latest Thoughts

Fed Chair Powell spoke on Tuesday morning in Portugal at an ECB forum and shared his latest thoughts on the economy, inflation, and rate cuts. He was generally dovish but didn’t seem overly anxious to cut interest rates. Below, we share a few poignant comments.

Inflation now shows signs of resuming its disinflationary trend.” “We are getting back on a disinflationary path.” “We’ve made a lot of progress.

I’m not going to be landing on any specific dates here today…so we’re aware that we have two-sided risks now, more so than we did a year ago. That’s a big change. I’d say risks are coming much more into balance now

The risk of inflation is that we act too fast

We are well aware of the risk going too soon and too fast

Inflation may get back to 2% late next year or the following year

As shown below, Fed Funds futures now imply an 83% chance the Fed will cut rates twice by year-end. The number of rate cuts has fluctuated between one and two over the previous two months.

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Let’s step back and ignore the last four years in which the economy cratered with the onset of the pandemic and then boomed on massive monetary and fiscal stimulus. Let’s also try to ignore the peak 6% core PCE inflation rate in 2022 and the historically low 3.4% unemployment rate in 2023. What if, in the years preceding the pandemic, we told you that in 2024, the Fed Funds rate would be 5.25-5.50%? You probably would have assumed inflation was at least 5% and the unemployment rate was exceptionally low.

The current unemployment rate is 4%, and the core PCE inflation rate is 2.6%. In December 2019, the unemployment rate was 3.6%, and the core PCE was 1.6%. At the time, Fed Funds were 1.5%. Here we sit today, with the unemployment rate .4% higher and core PCE 1% higher than in 2019. Yet, the Fed Funds rate is 4% more than in 2019. Does it seem a bit high? To help answer the question, consider the Fed’s long-term forecasts.

As we circle below, the Fed thinks the natural long-term unemployment rate is 4.2% and PCE 2.0%. Under such an outlook, the Fed believes Fed Funds should be 2.8%. While it’s hard to make a case for the Fed to cut rates today, a simple look at their two objectives, full employment and stable prices, and its long-term economic projections make one appreciate that the current Fed Funds rate is exceptionally high. Even if the economy continues to chug along without a recession, it appears that barring higher inflation, significant rate cuts in the coming year will be consistent with the Fed’s economic outlook.

What To Watch Today

Earnings

• No notable earnings releases today

Economy

Market Trading Update

As discussed yesterday, this is the beginning of a new quarter, the end of the first half, and the beginning of the Q2 earnings season. We noted that with this holiday-shortened week, volatility could certainly pick up. Unsurprisingly, I received several emails about the sharp sell-off in long-date Treasury bond ETFs. As shown, bond ETFs had a sharp reversal due to end-of-quarter rebalancing and dividend distributions yesterday, temporarily suppressing the price. However, bonds had enjoyed a very nice rally and were overbought going into quarter-end, so the sell-off is unsurprising

The economic data continues to show economic deterioration, which is bond-supportive, so the recent selloff in bond ETFs is likely presenting a good buying opportunity for traders. The last time bonds approached this level of oversold conditions was in April and May before a decent rally occurred.

Economic Surprise Index

We have read articles warning of an imminent recession due to the low economic surprise index. While we rule nothing out, it’s best to appreciate what the index tells us. Surprise indexes measure specific economic data forecasts versus the actual data. When the surprise index declines, it simply means that economic forecasters are generally overly optimistic. Hence, economic data is weaker than expected. Initially, that typically means the economy is slowing. However, economists are quick to adjust their forecasts for trend changes. Once this occurs, data may still deteriorate, but economists’ forecasts tend to be closer to reality or often overly pessimistic. Frequently, the surprise index will rebound. However, that doesnt mean the economy is improving, it only means forecasts are more realistic.

As shown below, the surprise index tends to oscillate. Low readings can precede a recession, but they occur with enough frequency they often prove to be a false alarm.

Sector Review- Materials Continue to Struggle

Over the last four weeks, the materials sector (XLB) has slipped by nearly 5% versus the S&P 500. Other than utilities, which are 6.5% worse than the S&P 500, it is the worst-performing sector over that period. Energy, which had the lowest relative SimpleVisor score for a few weeks running, was the market’s best-performing sector last week.

The second table, courtesy of SimpleVisor, shows the performance of each sector over consecutive periods ranging from the last five days to 20 and 60-day increments.

The third graph shows the price ratio of XLB to SPY. Other than XLB’s outperformance in the first quarter of 2024, XLB has been weak on a relative basis.

Some may say that the weakness in materials stocks is a telling signal about the state of the economy. We would counter, claiming that the service sector accounts for three-quarters of economic activity. The manufacturing sector has been in a recession for about two years, yet economic growth has been above average.

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Wall Street analysts continue significantly lowering the earnings bar as we enter the Q2 reporting period. Even as analysts lower that earnings bar, stocks have rallied sharply over the last few months.

As we have discussed previously, it will be unsurprising that we will see a high percentage of companies “beat” Wall Street estimates. Of course, the high beat rate is always the case due to the sharp downward revisions in analysts’ estimates as the reporting period begins. The chart below shows the changes for the Q2 earnings period from when analysts provided their first estimates in March 2023. Analysts have slashed estimates over the last 30 days, dropping estimates by roughly $5/share.

That is why we call it “Millennial Earnings Season.” Wall Street continuously lowers estimates as the reporting period approaches so “everyone gets a trophy.” An easy way to see this is the number of companies beating estimates each quarter, regardless of economic and financial conditions. Since 2000, roughly 70% of companies regularly beat estimates by 5%, but since 2017, that average has risen to approximately 75%. Again, that “beat rate” would be substantially lower if investors held analysts to their original estimates.

Analysts remain optimistic about earnings even with economic growth weakening, inflation remaining elevated, and liquidity declining. However, despite the decline in Q2 earnings estimates, analysts still believe that the first quarter of 2023 marked the bottom for the earnings decline. Again, this is despite the Fed rate hikes and tighter bank lending standards that will act to slow economic growth.

However, between March and June of this year, analysts cut forward expectations for 2025 by roughly $9/share.

However, even with the earnings bar lowered going forward, earnings estimates remain detached from the long-term growth trend.

As discussed previously, economic growth, from which companies derive revenue and earnings, must also strongly grow for earnings to grow at such an expected pace.

Since 1947, earnings per share have grown at 7.72%, while the economy has expanded by 6.35% annually. That close relationship in growth rates is logical, given the significant role that consumer spending has in the GDP equation. However, while nominal stock prices have averaged 9.35% (including dividends), reversions to underlying economic growth will eventually occur. Such is because corporate earnings are a function of consumptive spending, corporate investments, imports, and exports. The same goes for corporate profits, where stock prices have significantly deviated.

Such is essential to investors due to the coming impact on “valuations.”

Given current economic assessments from Wall Street to the Federal Reserve, strong growth rates are unlikely. The data also suggest a reversion to the mean is entirely possible.

The Reversion To The Mean

Following the pandemic-driven surge in monetary policy and a shuttering of the economy, the economy is slowly returning to normal. Of course, normal may seem very different compared to the economic activity we have witnessed over the last several years. Numerous factors at play support the idea of weaker economic growth rates and, subsequently, weaker earnings over the next few years.

1. The economy is returning to a slow growth environment with a risk of recession.
2. Inflation is falling, meaning less pricing power for corporations.
3. No artificial stimulus to support demand.
4. Over the last three years, the pull forward of consumption will now drag on future demand.
5. Interest rates remain substantially higher, impacting consumption.
6. Consumers have sharply reduced savings and higher debt loads.
7. Previous inventory droughts are now surpluses.

Notably, this reversion of activity will become exacerbated by the “void” created by pulling forward consumption from future years.

“We have previously noted an inherent problem with ongoing monetary interventions. Notably, the fiscal policies implemented post the pandemic-driven economic shutdown created a surge in demand and unprecedented corporate earnings.”

As shown below, the surge in the M2 money supply is over. Without further stimulus, economic growth will revert to more sustainable and lower levels.

While the media often states that “stocks are not the economy,” as noted, economic activity creates corporate revenues and earnings. As such, stocks can not grow faster than the economy over long periods. A decent correlation exists between the expansion and contraction of M2 less GDP growth (a measure of liquidity excess) and the annual rate of change in the S&P 500 index. Currently, the deviation seems unsustainable. More notably, the current percentage annual change in the S&P 500 is approaching levels that have preceded a reversal of that growth rate.

So, either the annualized rate of return from the S&P 500 will decline due to repricing the market for lower-than-expected earnings growth rates, or the liquidity measure is about to turn sharply higher.

Valuations Remain A Risk

The problem with Wall Street consistently lowering the earnings bar by reducing forward estimates should be obvious. Given that Wall Street touts forward earnings estimates, investors overpay for investments. As should be obvious, overpaying for an investment today leads to lower future returns.

Even with the decline in earnings from the peak, valuations remain historically expensive on both a trailing and forward basis. (Notice the significant divergences in valuations during recessionary periods as adjusted earnings do NOT reflect what is occurring with actual earnings.)

Most companies report “operating” earnings, which obfuscate profitability by excluding all the “bad stuff.” A significant divergence exists between operating (or adjusted) and GAAP earnings. When such a wide gap exists, you must question the “quality” of those earnings.

The chart below uses GAAP earnings. If we assume current earnings are correct, then such leaves the market trading above 27x earnings. (That valuation level remains near previous bull market peak valuations.)

Since markets are already trading well above historical valuation ranges, this suggests that outcomes will likely not be as “bullish” as many currently expect. Such is particularly the case if more monetary accommodations from the Federal Reserve and the Government are absent.

Trojan Horses

As always, the hope is that Q2 earnings and the entire coming year’s reports will rise to justify the market’s overvaluation. However, when earnings are rising, so are the markets.

Most importantly, analysts have a long and sordid history of being overly bullish on growth expectations, which fall short. Such is particularly the case today. Much of the economic and earnings growth was not organic. Instead, it was from the flood of stimulus into the economy, which is now evaporating.

Overpaying for assets has never worked out well for investors.

With the Federal Reserve intent on slowing economic growth to quell inflation, it is only logical that earnings will decline. If this is the case, prices must accommodate lower earnings by reducing current valuation multiples.

When it comes to analysts’ estimates, always remain wary of “Greeks bearing gifts.”

Jerome Powell and his Fed colleagues breathed a sigh of relief Friday morning as the PCE inflation report was weaker than expected. The headline PCE price index was +0.0% versus expectations of a 0.1% increase and a previous monthly change of +0.3%. The Core PCE was +0.1%, also a tenth below expectations. Recent inflation data provides hope that the trend lower in inflation will resume after stalling out for about six months. Further encouraging is the newly popular Supercore PCE reading, a subset of inflation, which was only up 0.1%. This index surged by 0.8% in January, causing the Fed and the market to reduce their expectations for a Fed rate. This report provides further evidence that the instance was a one-time spike and not likely a trend reversal.

Supercore prices, accounting for roughly 50% of PCE, include the prices of core services, excluding housing. The Fed has mentioned Supercore PCE on numerous occasions. Their rationale for following it is that many of the categories in the Supercore calculation are labor-intensive sectors. Therefore, Supercore PCE is a decent indicator of tightness in the labor markets, which can impact wages and, ultimately, inflation. The graphs below, courtesy of ZeroHedge, break out Supercore by its components. If it weren’t for health insurance, Supercore PCE would have been negative. Five of the eight components are negative, with one at essentially zero and two (healthcare and food service/accommodations) positive.

What To Watch Today

Earnings

• No notable reports today.

Economy

Market Trading Update

Last week, we did an in-depth discussion of the worsening breadth of the market. However, the important point was that investors make two mistakes regarding such data. To wit:

“The first is overreacting to these technical signals, thinking a more severe correction is coming. The second is taking action too soon.

Yes, these signals often precede corrections, but there are also periods of consolidation when the market trades sideways. Secondly, reversals of overbought conditions tend to be shallow in a momentum-driven bullish market. These corrections often find support at the 20 and 50-day moving averages (DMA), but the 100 and 200-DMAs are not outside regular corrective periods.

If you remember, in March, we discussed the potential for a 5% to 10% correction due to many of the same concerns noted above. That correction of 5.5% came in April. We are again at a juncture where a 5-10% correction is likely. The only issue is that it could come anytime between now and October. As is always the case, timing is always the most significant risk.”

As shown, the market’s monthly seasonality supports that view of a potential correction later this summer. July tends to be a decent performance month, with an average return of more than 2%.

That boost in performance in July is supported by the kick-off of the Q2 earnings season. Such is particularly the case as investor sentiment is extremely bullish, which will continue to put a bid under stocks in the short term.

Speaking of earnings, analysts have been extremely busy over the last 30 days, slashing estimates. In June, Q2 earnings estimates for the S&P 500 index were cut by $5/share to the lowest level yet. Interestingly, while Wall Street continues to boast confidence in rising asset prices, they have cut estimates from $214/share in March last year to just $193/share. Such suggests a dichotomy between expected market performance and the economy, which is where earnings come from.

Nonetheless, the market remains overbought short-term and has triggered a short-term MACD “sell signal,” which could limit the upside in the near term. Continue to manage portfolio risk accordingly, but the bullish trend remains intact for now.

The Week Ahead

Despite the holiday-shortened week, investors will have plenty of economic data to digest. The ISM manufacturing survey will be released on Monday, and the services survey will be released on Wednesday. After Friday’s robust Chicago PMI survey, investors will look for confirmation in the ISM reports. Employment data, including JOLTs on Tuesday, ADP on Wednesday, and the BLS employment report on Friday, will be the most critical data points of the week. Recent jobless claims data point to some weakness in the labor markets.

Jerome Powell will be speaking on Tuesday at 8:30. By that time, he may have a good sense of what the BLS employment report holds. Further, investors will be looking to see if the recent weakness in economic data is starting to sway the Fed’s comfort regarding cutting rates. The next Fed meeting is July 31st.

Nike and Walgreens Tumble On Weakening Sales

Nike and Walgreens’ off-calendar earnings highlight a continuation of weakening personal consumption. In late May, we discussed this troubling theme in retail and food services earnings. Those Commentaries can viewed HERE and HERE.

On Thursday night, Nike disclosed that it bettered earnings expectations by .17 cents due to cost-cutting. However, it missed revenue forecasts by $250 million. Furthermore, they guided expectations down for fiscal year 2025. Nike can no longer hike prices to keep up with inflation, which indicates that the consumer is becoming more frugal. They also speak to weakness in China. Many companies have echoed similar sentiments about China’s economy.

NIke’s poor earnings are not just about slowing consumption. It also appears that “lifestyle brand competitors” are taking market share from Nike. Per the CEO:

There was a shift in our lifestyle brands that caught us by surprise, and without new products, we’ve had less interest. Newness is driving the consumer and we’ve got to move to more newness. We are also chasing our competition in women’s apparel and running. We said last quarter we had a new playbook that will start our comeback with new innovations. We aren’t there yet, and our numbers are going to be worse in 2025 than we previously thought.

Walgreens also struggles partly due to weaker consumption. Like Nike, it is losing market share due to its business model. They reported earnings of $.63, $.05 short of estimates. However, revenues were slightly better than expected. While revenues were okay, they lowered EPS guidance from $3.20-$3.35 to $2.80-$2.95. Further, they are Closing 25% of their 8,600 stores over the next three years, which will lead to a decrease of 57,000 employees.

“We assumed the consumer would get somewhat stronger,” but “that is not the case,” said Walgreens CEO.

In regards to their business model, he states:

We are at a point where the current pharmacy model is not sustainable, and the challenges in our operating environment require we approach the market differently.

As we share below, NKE opened trading about 15% lower on the news last Friday and is at five-year lows. Walgreens is down about 20% since earnings. It has declined by 80% over the last five years, sitting at its lowest price since 1997!

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